The benefits of a Limited Liability Company in California are the topic of this blog post. A Limited Liability Company (LLC) has several advantages over a corporation in that an LLC is not subject to the same onerous recordkeeping requirements of a corporation such as corporate minutes, bylaws, directors, and shareholders. An LLC also offers more asset protection as well. These advantages are the reason that forming an LLC in California has become more and more popular.
A California corporation does not offer the same asset protection features as an LLC in that although the personal creditors of a debtor-shareholder cannot directly take over ownership of the assets of the corporation they can obtain ownership of the stock of a debtor-shareholder in which case they step into the shoes and become a co-owner of the corporation which entitles them to the share of the debtor-shareholder of the corporation’s profits and to participate in the management of the corporation. And if they can obtain ownership of at least 51% of the stock of the corporation they can have the corporation liquidated and its assets sold to pay off the debt of the debtor-shareholder.
The law in California along with the law in most states is that a creditor cannot take the money or property of a California LLC to pay off the personal debts or liabilities of the owners of the LLC.
In California creditors are limited to certain specified remedies including
Obtaining a charging order requiring that the LLC pay the creditor money distributed to the debtor-owner;
Foreclosing on the debtor-owner’s LLC ownership interest, or
Getting a court to order the LLC to be dissolved and all its assets sold.
California allows the creditors of an owner of a California LLC to obtain what is known as a charging order the membership interest of the debtor-owner. A charging order is an order issued by a court directing the manager of an LLC to pay to the creditors of the debtor-owner any distributions of income or profits from the LLC that would otherwise be distributed to the debtor-member.
However a charging order has limitations as even creditors with a charging order in California only obtain the financial rights to payment of the debtor-owner, they do not participate in the management of the LLC. This means that no creditor can order the LLC to make a distribution that is subject to its charging order. Many creditors who obtain charging orders still end up with nothing because they can’t order any distributions and as a result they are not a very effective collection tool for creditors except in unusual circumstances.
The law in California states that a creditor who obtains a charging order but is not paid by the LLC is allowed to request a court order that the LLC membership interest of the debtor be foreclosed upon. However due to changes in California law that took effect in 2014, namely Corporations Code § 17705.03.b)(3) cannot order a foreclosure unless the creditor can make a showing that any distributions under a charging order will not pay the judgment debt within a reasonable time. Basically the creditor will have to show that the earnings of the LLC have been continually withheld for purposes of reinvestment instead of being distributed to the members of the LLC. This means that a creditor will have to wait for some time before any foreclosure can be ordered.
If the LLC interest of the debtor is foreclosed upon the court will order that the financial rights of the debtor in the LLC will be sold. In all likelihood the creditor would be the one purchasing the interest because few if any people would want to purchase those rights at the foreclosure sale. In the event that happens the creditor essentially becomes the permanent owner of the financial rights of the debtor, including the right to receive money from the LLC. However the creditor cannot participate in any way in the management of the LLC meaning that it cannot force the LLC to pay it or anyone else any amount of money. In fact it is possible that before the foreclosure sale the debtor or other members of the LLC will settle the debt with the creditor. If they do not settle the debt that means the debtor will not be entitled to any share of the assets of the LLC in the event it is dissolved.
California law does not allow the personal creditors of an LLC member to obtain a court order that the LLC be dissolved so that its assets can be sold to pay off the creditor.
In order to increase the level of asset protection the operating agreement for the LLC should include a provision that allows the other Members the right of first refusal if another Member wishes to sell their interest in the LLC, or if a creditor obtains a charging order against a Member.
Most authorities recommend that an LLC should have at least two members to increase the potential liability protection from personal creditors. This is due to the fact that it is at least theoretically possible that a California court could agree with what a growing number of courts in other states have done and apply a different rule for a single member LLC.
Attorneys or parties in California that would like to view a portion of a sample 9 page California Limited Liability Company Operating Agreement that includes a provision that allows the other Members the right of first refusal if another Member wishes to sell their interest in the LLC, or if a creditor obtains a charging order against a Member sold by the author can see below.
The author of this blog post, Stan Burman, is a freelance paralegal who has worked in California and Federal litigation since 1995.
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Copyright 2015 Stan Burman. All rights reserved.
Please note that the author of this blog post, Stan Burman is NOT an attorney and as such is unable to provide any specific legal advice. The author is NOT engaged in providing any legal, financial, or other professional services, and any information contained in this blog post is NOT intended to constitute legal advice.
These materials and information contained in this blog post have been prepared by Stan Burman for informational purposes only and are not legal advice. Transmission of the information contained in this blog post is not intended to create, and receipt does not constitute, any business relationship between the author and any readers. Readers should not act upon this information without seeking professional counsel.