Why an LLC is Not Ideal For Asset Protection

What Is an LLC?

A hybrid of the "S" Corporation and a partnership, an "LLC" combines the corporate characteristic of limited liability with the tax advantages and flexibility of partnerships.

What Protection Does an LLC Offer?

Being a member of an LLC offers more protection to the members interest, which makes an LLC very attractive. A creditor can only get a charging order against a member of an LLC and cannot go after the LLC's assets directly. They must instead obtain a charging order from a court, which is not a preferred remedy for a creditor.

What Is a Charging Order?

With a charging order, a creditor has the right to receive any distributions in which the owner of the interest is entitled to. A charging order is issued by the court and instructs the manager(s) to give the distributions that the debtor would ordinarily be entitled to to the creditor until the unpaid judgment is satisfied.

Illinois LLC Act

At first glance, the Illinois LLC Act appears to protect the assets of an LLC. Specifically, Section 30-20 provides that a charging order is available to creditors of the members of an LLC. More importantly, 805 ILCS 180/30-20(e) states:

  1. This Section provides the exclusive remedy by which a judgment creditor of a member or a transferee may satisfy a judgment out of the judgment debtor's distributional interest in a limited liability company.

If you have any questions regarding the legal aspects of asset protection, contact the Chicago business attorneys at Bellas & Wachowski for further guidance.

A person could easily be led astray by this wording and believe that simply by putting assets in an LLC, creditors will not be able to reach them. Even with a charging order, a creditor is only entitled to the distributions from the LLC; they are not entitled to the assets themselves. However, this thinking is faulty for several reasons which will be discussed below. Like a person trying to protect their assets who uses tools such as an LLC to do so, creditors also have an arsenal of tools at their disposal to gain access to these assets.

What Not to Do - Fraudulent Conveyance

Under the Uniform Fraudulent Transfer Act, a creditor of a member of an LLC can claim the transfer of the assets into an LLC was not an authentic transfer, but was instead a fraudulent transfer. A transfer is considered fraudulent if the intent of the debtor is to defraud a creditor or if there is a transfer without reasonable value in which the debtor is going to conduct business without having sufficient remaining assets or the debtor knows or reasonably should have known that they would incur debts without the ability to pay the debt back. The actual intent of the debtor is determined by several factors, such as, but not limited to: whether the transfer was concealed, the debtor was sued or threatened with a lawsuit before the transfer, the debtor was insolvent, or if the debtor hides assets. Again, this is not an exhaustive list and other factors can be considered, as determined by the court.

A shining example of a court setting aside a conveyance due to a fraudulent transfer is Firmani v Firmani, 332 NJ Super 118, 752 A2d 854 (2000). An ex-wife was due $25,000 from her former husband. The ex-husband claimed he transferred his residence, which had approximately $83,000 in equity, to a family partnership as part of his estate planning. The husband held a one percent interest as the general partner and a ninety-four percent interest as a limited partner. The remaining five percent was held by the present wife, three children, and a stepson.

The court in Firmani looked at factors known as "badges of fraud" to determine whether a transaction was intended to defraud creditors. These "badges of fraud" allows the court to infer the intent to defraud creditors. A single factor may be sufficient to allow the court to conclude that a transaction was fraudulent. A strong inference of fraud is implied when there are several "badges of fraud." The court was not satisfied with the husband's claim that the conveyance was for "estate planning purposes," and the husband offered no other evidence to the contrary. The court concluded that the transfer was fraudulent and the charging order therefore substantially hindered and delayed the ex-wife in attempting to collect.

Bankruptcy

In order to be an effective asset protection tool, the LLC must be able to survive the members bankruptcy if a declaration of bankruptcy becomes necessary. The Bankruptcy Act, 11 USC 548, has a provision very similar to the Fraudulent Transfer Act. Section (e) of the Act states:

In addition to any transfer that the trustee may otherwise avoid, the trustee may avoid any transfer of an interest of the debtor in property that was made on or within 10 years before the date of the filing of the petition, if

  1. such transfer was made to a self-settled trust or similar device;
  2. such transfer was by the debtor;
  3. the debtor is a beneficiary of such trust or similar device; and
  4. the debtor made such transfer with actual intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made, indebted.

Based on this section, the question would be whether the bankruptcy court would categorize an LLC as a "similar device."

Another potential problem area in bankruptcy is the single-member LLC. Looking at In re Albright, 291 BR 538 (Colo D 2003), which is not binding precedent but will be used as a persuasive argument in bankruptcy courts in other jurisdictions, we can predict the outcome when the charging orders for single-member LLCs are questioned. The court held that the bankruptcy trustee was entitled to both the economic rights and the management rights of the member because there were no other member rights at issue due to the LLC being a single member LLC. The trustee was then permitted to sell the property that was placed in the LLC so creditors could be paid off. This outcome suggests that a single member LLC will not protect assets.

Reverse Veil-Piercing

In a traditional veil-piercing case, the corporation's limited liability protection is "pierced" and the court finds an owner personally liable usually to avoid some form of unjust enrichment. Reverse piercing happens when a creditor pierces the corporate veil and is allowed access to the corporation's assets in order to satisfy a creditor's claim.

In looking at two sections of the Illinois Limited Liability Company Act, 805 ILCS 180/1 and 180/35-1, it appears to afford a creditor the option of a reverse veil-piercing of a member of an LLC. Section 30-20(b) and 180/35-1 respectively states:

(b) A charging order constitutes a lien on the judgment debtor's distributional interest. The court may order a foreclosure of a lien on a distributional interest subject to the charging order at any time. A purchaser at the foreclosure sale has the rights of a transferee.

Events causing dissolution and winding up of company's business. A limited liability company is dissolved, and, unless continued pursuant to subsection (b) of Section 35-3, its business must be wound up, upon the occurrence of any of the following events...(5) On application by a transferee of a member's interest, a judicial determination that it is equitable to wind up the company's business.

Reading these two sections, it appears that the creditor who is not able to satisfy their claim with a charging order, is allowed to petition the court for foreclosure of the member's interest with a lien. If the debt is still unsatisfied and the creditor has in fact bid at the foreclosure sale, could then petition the court for an order to dissolve and wind up the company. During the dissolution and winding up all creditor claims must be satisfied, even if assets are forced to be sold to do so.

Although an LLC is attractive for other purposes, it should be used with extreme caution if the purpose is asset protection. The above theories are tools that can be utilized by creditors to gain access to an LLC member's assets.

Authored by Misty J. Cygan