Because of a recent court case, there is some confusion regarding whether a single- member LLC offers effective asset protection, and whether it would be preferable to instead form only multi-member LLC’s for this purpose. In order to clear up any misconceptions, let’s analyze this case and see what we can find out.
The case in question is part of a Chapter 7 bankruptcy proceeding, which occurred in the state of Colorado (In re: Ashley Albright, Case No. 01-11367, U.S. Bankruptcy Court for the district of Colorado.) Ashley Albright was the sole member and manager of Western Blue Sky LLC. The LLC held real estate property in Colorado. Ashley Albright filed Chapter 13 bankruptcy, which was then converted to Chapter 7 bankruptcy in July, 2001.
After declaring bankruptcy, the trustee of the bankruptcy estate filed a motion to obtain exclusive ownership and control of Western Blue Sky LLC, in order to liquidate its assets as payment to Ashley’s creditors. Ms. Albright argued that since the property was in an LLC, the trustee was only entitled to distributions from the LLC, and not to the assets or a membership interest in the LLC itself.
It is very important to note the primary law, which the judge refers to in this case, is the Colorado Limited Liability Company Act. The judge ultimately decides that in a bankruptcy proceeding, although the Colorado LLC Act prohibits anyone from gaining a membership or management interest in a multi-member LLC without the non-debtor members’ consent, that this same restriction does not apply to a single-member LLC. Here is an excerpt from the case, which explains the judge’s line of reasoning (all emphasis is mine):
Pursuant to the Colorado limited liability company statute, the Debtor’s membership interest constitutes the personal property of the member. Upon the Debtor’s bankruptcy filing, she effectively transferred her membership interest to the estate. See 11 U.S.C. § 541(a). n4 Because there are no other members in the LLC, the entire membership interest passed to the bankruptcy estate, and the Trustee has become a “substituted member.” n5
n4 11 U.S.C. § 541(a)(1) provides, in relevant part: “The commencement of a case…creates an estate. Such estate is comprised of … all legal or equitable interests of the debtor in property as of the commencement of the case.”
n5 Colo. Rev. Stat. § 7-80-702 provides (emphasis added):
(1) The interest of each member in a limited liability company constitutes the personal property of the member and may be transferred or assigned. However, if all of the other members of the limited liability company other than the member proposing to dispose of his or its interest do not approve of the proposed transfer or assignment by unanimous written consent, the transferee of the member’s interest shall have no right to participate in the management of the business and affairs of the limited liability company or to become a member. The transferee shall only be entitled to receive the share of profits or other compensation by way of income and the return of contributions to which that member would otherwise be entitled.
(2) A substituted member is a person admitted to all the rights of a member who has died or has assigned his interest in a limited liability company with the approval of all the members of the limited liability company by unanimous written consent. The substituted member has all the rights and powers and is subject to all the restrictions and liabilities of his assignor; except that the substitution of the assignee does not release the assignor from liability to the limited liability company under section 7-80-502.
Section 7-80-702 of the Limited Liability Company Act requires the unanimous consent of “other members” in order to allow a transferee to participate in the management of the LLC. n6 Because there are no other members in the LLC, no written unanimous approval of the transfer was necessary. Consequently, the Debtor’s bankruptcy filing effectively assigned her entire membership interest in the LLC to the bankruptcy estate, and the Trustee obtained all her rights, including the right to control the management of the LLC. n7
n6 This reading of § 7-80-702 is reinforced in Colo. Rev. Stat. § 7-80-108(3)(a). Section 108 sets forth the effect of an operating agreement and what provisions are non-waivable. Section 108(3) states that “unless contained in a written operating agreement or other writing approved in accordance with a written operating agreement, no operating agreement may […] vary the requirement under section 7-80-702(1) that, if all of the other members of the limited liability company other than the member proposing to dispose of the member’s interest do not approve of the proposed transfer or assignment by unanimous written consent, the transferee of the member’s interest shall have no right to participate in the management of the business and affairs of the limited liability company or to become a member.” Colo. Rev. Stat. § 7-80-108(3)(a). The clause “other than the member proposing to dispose of the member’s interest” confirms that the “other members” identified in § 7-80-702 does not include the transferee.
At this point, it behooves us to point out a few things about this court case. First, the Colorado LLC Act makes a membership interest a person’s personal property. Second, this is a bankruptcy proceeding, and in Chapter 7 bankruptcy, an individual’s non-exempt personal property is transferred to the bankruptcy estate. Ashley Albright contends that the “charging order” provisions in the Colorado LLC Act prevent this from happening. However, the judge explains that this is not so, in the case of a single-member LLC, because there are no other members to object to the transfer of Ashley’s membership interest. There is an important part of the Colorado LLC Act that the judge does not elaborate on however. It is outlined above, and I’ll restate it here:
“if all of the other members of the limited liability company other than the member proposing to dispose of the member’s interest do not approve of the proposed transfer or assignment by unanimous written consent, the transferee of the member’s interest shall have no right to participate in the management of the business and affairs of the limited liability company or to become a member…”
The judge talks about the “other members” in his opinion, but he doesn’t elaborate on the part of the statute that says “the member proposing to dispose of the member’s interest.”
The member who is proposing to dispose of the member’s interest is, of course, Ashley Albright. When, then, did she propose to dispose of her interest? When she declared bankruptcy. “Upon the Debtor’s bankruptcy filing, she effectively transferred her membership interest to the estate.” (See the first paragraph of the case excerpt, above.) What this means, then, is that in the state of Colorado, a single-member LLC won’t protect one’s assets in a bankruptcy proceeding, because when a single LLC’s member declares bankruptcy, they are essentially declaring the transfer of their membership interest in the LLC to the bankruptcy estate. This also means that the LLC acts of other states may likewise offer no asset protection to a single-member LLC in a bankruptcy proceeding. This will depend, of course, on a state’s LLC statutes. The New Mexico LLC Act is written in a manner to, in PF Shield’s opinion, offer more protection to a single-member New Mexico LLC (in a bankruptcy proceeding) than Ms. Albright’s Colorado LLC offered her. However, the law is not completely clear on this matter, and this is an admitted gray area. Things could go either way. here is another section of this court case that also should be carefully scrutinized:
“The Debtor argues that the Trustee acts merely for her creditors and is only entitled to a charging order against distributions made on account of her LLC member interest. n8 However, the charging order, as set forth in Section 703 of the Colorado Limited Liability Company Act, exists to protect other members of an LLC from having involuntarily to share governance responsibilities with someone they did not choose, or from having to accept a creditor of another member as a co-manager. A charging order protects the autonomy of the original members, and their ability to manage their own enterprise. In a single-member entity, there are no non-debtor members to protect. The charging order limitation serves no purpose in a single member limited liability company, because there are no other parties’ interests affected.”
This excerpt may prove to be the most dangerous part of the court opinion to single-member LLC’s. Although this excerpt is only talking about the Colorado Limited Liability Company Act, it may set a precedent for similar rulings towards LLC’s organized in other states, even in non-bankruptcy cases. This is less likely to occur with some state’s LLC laws than with others, depending on how the LLC laws are written, but we must also throw into the fray the fact that a New Mexico LLC, for example, may be judged under another state’s laws, if that New Mexico LLC holds assets or does business in another state. Therefore, because it is not always clear which state’s laws will be given jurisdiction in any given court proceeding, PF Shield recommends that, for maximum asset protection, a multi-member LLC is preferable over a single-member LLC. This contention is actually reinforced by another segment from the Ashley Albright case:
“n7 Under Colo. Rev. Stat. § 7-80-702, supra, the result would be different if there were other non-debtor members in the LLC. Where a single member files bankruptcy while the other members of a multi-member LLC do not, and where the non-debtor members do not consent to a substitute member status for a member interest transferee, the bankruptcy estate is only entitled to receive the share of profits or other compensation by way of income and the return of the contributions to which that member would otherwise be entitled.
…
n9 The harder question would involve an LLC where one member effectively controls and dominates the membership and management of an LLC that also involves a passive member with a minimal interest. If the dominant member files bankruptcy, would a trustee obtain the right to govern the LLC? Pursuant to Colo. Rev. Stat. § 7-80-702, if the non-debtor member did not consent, even if she held only an infinitesimal interest, the answer would be no. The Trustee would only be entitled to a share of distributions, and would have no role in the voting or governance of the company. Notwithstanding this limitation, 7-80-702 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. 11 U.S.C. § § 544(b)(1) and 548(a)”
Notice that this excerpt mentions fraudulent transfers, and that a multi-member LLC, which is set up so as to hinder, delay or defraud creditors, will not necessarily protect the LLC members from its creditors like it otherwise would. This is why an asset protection program needs to be structured so as to minimize its vulnerability to a fraudulent transfer ruling. To summarize our analysis of In re: Ashley Albright, PF Shield contends that:
- A Colorado single-member LLC offers no asset protection in a bankruptcy proceeding.
- This may also be the case for bankruptcy proceedings that involve single-member LLC’s from other states, depending on a variety of factors.
- That a single-member LLC may or may not effectively protect its members assets from an external creditor attack, depending on a variety of factors, and
- That this case reinforces the fact that multi-member LLC’s generally offer excellent asset protection.
Of course, we must remember that there is sometimes a trade-off between more asset protection or more privacy. In re: Ashley Albright shows us such a trade-off. If we choose a single-member LLC, we can have more privacy, but potentially less asset protection. If we choose a multi-member LLC, then we are now expected to file a K-1065 return, which compromises our privacy somewhat, but we now have greater asset protection.