Limited liability companies have certain advantages, such as allowing owners to enjoy liability protection similar to a corporation while being taxed like a partnership, thus avoiding double taxation. But an LLC also has disadvantages, such as when one member, or owner, becomes insolvent and has to declare bankruptcy. Even if there are only two members in an LLC, one member becoming insolvent doesn't necessarily mean that the LLC has to dissolve, but it can cause problems. Because an LLC is an independent legal entity formed under state laws, those laws dictate what follows.
State LLC laws are modeled after partnership law, which prevents bankruptcy trustees or creditors from unilaterally transferring an insolvent member's ownership interests to a third party. This rule is in place so that the other member or members of an LLC aren't forced to be in a partnership with people they don't choose, such as a bankruptcy trustee or a third party. Even if the bankruptcy trustee liquidates the insolvent member's financial interest in the LLC and sells it to a third party, the other LLC members still have to agree before this third party can have any role in management decisions for the LLC. If there are only two members in the LLC, the remaining member must agree to share management decisions with the new owner.
In most states, LLC statutes prevent creditors from seizing any LLC assets before they are distributed to the insolvent member. Once any profits are distributed, however, creditors can request that the bankruptcy trustee force the insolvent member to use any profits he receives from the LLC to help pay off his debt. In New York, for example, the bankruptcy trustee can take the insolvent member's profit and income stream from the LLC and direct it to solely pay off the insolvent member's debts.
Most state laws give the remaining LLC member or members an automatic option to buy out the insolvent member when he files for bankruptcy. This is partially so that the ownership interest doesn't get tied up in bankruptcy proceedings and hurt the LLC's operations. This right allows the remaining member or members to continue running the LLC without having to dissolve the company due to the insolvency of one member. There are a few exceptions, however. In some states, any disruption to membership, including a bankruptcy declaration, automatically results in the dissolution of the LLC.
The operating agreement of an LLC can also play a key role in what happens when a member declares bankruptcy. The members of an LLC typically enter into an operating agreement when they first form the LLC. This agreement dictates how the LLC will be managed. In New York, for example, members can choose to have a qualification in their operating agreement that requires the LLC to dissolve upon one member's bankruptcy, even though New York law itself doesn't require this to happen.