Structuring a business strategically plays a major role in optimizing benefits and in protecting the business from potential issues. By exploring the different pros and cons of each business structure, including the tax benefits, operational flexibility, and protection of business interests each offers, business owners can work towards setting up the business for success right from the start.
Another important facet of strategically structuring a business is to plan for the unexpected and put in place safety nets and contingency plans in the event of a business threat. This is the core principle of risk mitigation.
What happens if a business owner is unable or unwilling to pay off a personal debt? Can creditors come after their business assets? It depends.
If the business is structured as a sole proprietorship, a limited partnership, or a general partnership, the business owner may be at risk of losing business assets to pay off debts.
A corporation offers some protection against personal creditors, but there is a risk that creditors can take over the share of the debtor and, if the share is big enough, may have the ability to liquidate the business to pay off any debts, putting other shareholders at risk.
Limited Liability Companies (LLCs) protect the business owner/LLC member from the liabilities of the business, but what protects the business and other LLC members from the actions or debts of the owner or the LLC member in debt? Certain states establish the charging order as the sole remedy for creditors of LLC members.
What is a Charging Order?
A charging order is a lien that a creditor can put on the debtor’s LLC interest/share in the business without affecting the other members of the LLC.
Charging orders protect an LLC and other members of an LLC from the personal debts of the debtor member. That is, creditors pursuing an LLC member cannot go after the assets of the company or the assets of the other members.
When a creditor is owed money, the creditor seeks a Charging order from the court to place a lien on the debtor, or on the debtor’s interest in the LLC. From here, the debtor’s profits/dividends will go to the creditor to pay off debts without affecting the other members of the LLC.
Creditors can also obtain charging orders against corporations; however, there is one major advantage that LLCs have: unlike corporations, the creditor cannot take over the debtor’s shares of the business.
What is a Charging Order protection?
A charging order protection puts limitations on creditors and provides protection for the business.
With charging order protection, businesses can:
- Ensure that operations are not disrupted
- Maintain business confidence and continuity
- Limit creditors’ access to the business
Jurisdiction as a Business Strategy Consideration for Charging Orders
Creditors file charging orders with the state court for debts owed. For business owners and LLC members, understanding how the jurisdiction in which the business is registered may impact the charging orders is key.
Savvy business owners understand that threats to the business can be internal as well as external, and protections must be put in place to ensure that the business’ and the members’ interests are protected.
The majority of states offer charging order protections for multi-member LLCs. This is not the case for single-member LLCs, simply because charging order protection for single-member LLCs defeats the premise of a charging order—to protect the business and other members from financial loss due to the personal debt of other members.
The states below have the strongest charging order protection for multi-member LLCs and restrict creditors from forcing the sale or foreclosing on the debtor’s interest:
- Alaska
- Delaware
- Nevada
- South Dakota
- Wyoming
However, there are a few states that offer limited protection for LLCs and additional opportunities for creditors to seek repayment of debts owed, which include California, Florida and New Hampshire.
A Word on California Charging Order Protection for LLCs
If protection against creditors is a priority, businesses may opt to register their LLCs outside the State of California. This is due to the limited charging order protection the state offers businesses.
In most states, creditors are limited to accessing only the profits and dividends of the defaulting party and have no voting or management authority or the ability to foreclose on the membership interest of the debtor member.
California provides the same protections except that the revised Uniform LLC Act now gives creditors the ability to foreclose on the debtor member’s interest in the LLC if they can prove that the profits and dividends will not pay off the debt within a reasonable time period. However, the business and other members’ interests will continue to be protected as the creditor cannot participate in the management of the business and cannot affect the dissolution of the business.
Conclusion
Charging orders protect the financial interests of multi-member LLCs from internal threats such as the creditor’s actions against a debtor member of the LLC. In many states, it is the exclusive remedy for creditors, with some states offering stronger protections compared to others. Conversely, some states, like California, give creditors additional recourse to go after unpaid debts. This may lead to hesitation for some California-based entrepreneurs who are considering the best way to structure their business; however, it is vital to weigh all the advantages and disadvantages of each business structure and geographic location present when setting up a business.
Jacko Law Group works with clients who are considering or are in the process of structuring or restructuring their businesses. If you have any questions or require legal counsel on how to best mitigate risks and optimize your business, please call 619.298.2880 or email info@jackolg.com.
Author: Eric M. Leander, Senior Attorney, Jacko Law Group, PC (“JLG). JLG works extensively with investment advisers, broker-dealers, investment companies, private equity and hedge funds, banks and corporate clients on securities and corporate counsel matters. For more information, please visit https://www.jackolg.com/.
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