• Limited Liability Company Doesn't Protect Its Property Against Member's Bankruptcy
  • July 15, 2003 | Author: Harris Ominsky
  • Law Firm: Blank Rome LLP - Philadelphia Office
  • A limited liability company protects its principal's property against creditors of the LLC. But according to a recent case, the LLC will not protect its property against its principal's creditors.

    The case of In re Ashley Albright, 2003 Bankr.Lexis 291 Bank. D.Colo. April 4, 2003), held that when the sole member of an LLC goes into bankruptcy, the bankruptcy trustee then controls the LLC and can sell its real estate and distribute the proceeds to the bankruptcy estate. Albright was the sole member and manager of Western Blue Sky LLC which owned real estate in Colorado. When Albright ran into financial trouble she filed a Chapter 13 bankruptcy petition that was later converted to a Chapter 7 liquidation. Because the Western Blue Sky LLC did not go into bankruptcy, Albright argued that the trustee acted only for Albright's creditors and at best was entitled to a statutory charging order against distributions made on account of Albright's membership interest. Also she argued that the trustee could not assume management of the LLC or sell its property.

    Trustee Controls LLC

    The bankruptcy court disagreed with this position based on the Colorado LLC statute under which Albright's membership interest constituted the personal property of the member. The court held: "...[b]ecause there are no other members in the LLC, the entire membership interest passed to the bankruptcy estate and the trustee became a 'substituted member'." The court also stated that, "upon the Debtor's bankruptcy filing, the Trustee now controls, directly or indirectly all governance of the entity, including decisions regarding liquidation of the entity's assets." The court stated that because there were no other members in the LLC, no written unanimous approval of the transfer was necessary, as would be the case if there were other members -- no matter how small such other membership interest may be.

    In rejecting Albright's assertion that the trustee should be entitled only to a charging order, it held that a charging order existed only to protect other members of an LLC, and in a single-member LLC there were no non-debtor members to protect. Therefore trustees, as sole members of an LLC, control the LLC and can cause it to sell its property and distribute the proceeds to the bankruptcy estate, or alternatively trustees could elect to distribute the LLC's property to the bankruptcy estate and than liquidate the property themselves.

    Peppercorn Co-Members

    It is noteworthy that according to this case, a party forming an LLC to hold real estate could avoid this result simply by having another nominal member in the LLC. Colorado's LLC statute, which is similar to those in other states, provides that if the unanimous consent of all members in a multi-member LLC is not obtained, the bankruptcy estate is only entitled to receive the bankrupt member's share of the profits or other compensation that the bankrupt member was otherwise entitled to, and would not be entitled to any role in voting or governance of the LLC.

    Also, it is not clear whether the decision would have come out differently if the LLC had a binding contract with an independent manager. The court did not have to face that issue since Albright acted both as a single member and manager.

    However, the court pointed out in a footnote that this statutory limitation "does not create an asset shelter for clever debtors. To the extent a debtor intends to hinder, delay or defraud creditors through a multi-member LLC with 'peppercorn' co-members, bankruptcy avoidance provisions and fraudulent transfer law would provide creditors or a bankruptcy trustee with recourse."

    In Pennsylvania, because LLC's are not complete "pass-through" entities for state corporate taxes, tax planners prefer to use limited partnerships to protect the principals against liability to creditors of the entity. Otherwise, the LLC will wind up paying state capital stock taxes and be treated like a corporation for that purpose.

    To avoid this result, sometimes planners will structure real estate ownership by setting up a limited partnership with a single member LLC acting as the general partner and holding a small percentage interest. The principal can be the single member of the LLC, and also the limited partner, thereby providing the partnership with two partners and protecting the limited partner against third party liability in the same way as if the general partner were a corporation.

    Unfortunately, if the principal should go into bankruptcy, under the Albright case the bankruptcy trustee may apply the same logic and take over control of the real estate owned by the partnership. By that logic, the trustee could succeed to the debtor's interest as a limited partner, and also to the debtor's control of the single-member LLC.

    LLC Like Blue Sky

    In substance, it is not clear how much more the debtor's creditors will receive from this enhanced trustee's power as contrasted with what would have happened if the case went the other way. While the court doesn't discuss this, the trustee's rights to the real estate would seem to be subject to the rights of the LLC's creditors. Even without control of the sale of the property, the trustee would succeed to the debtor's interest in the LLC, and indirectly to the LLC's assets, which include its real estate. As a practical matter, that real estate owned by the LLC would still seem to be of substantially the same value to the debtor's creditors.

    Generally, an LLC is a tax-pass-through entity ignored for federal tax purposes, and ignored for state taxes in most states. In the Ashley Albright case, the LLC is also being ignored for bankruptcy purposes.

    In the hope that our readers will forgive a slight literary flourish, we point out that the name of the LLC, "Western Blue Sky," is somewhat prophetic. In this case, the bankruptcy court has made it clear that the LLC is, in effect, as translucent and unsubstantial as the western blue sky.