LLC Bankruptcy Laws

By Beverly Bird

The bankruptcy laws pertaining to limited liability companies are hazy. The United States Bankruptcy Code contains no specific provisions for LLCs, so bankruptcy courts often look to state laws to decide what to do when such a company files for protection. However, some trends have developed since states began to recognize LLCs as legal entities in the 1980s, even though there are few hard and fast rules.

The bankruptcy laws pertaining to limited liability companies are hazy. The United States Bankruptcy Code contains no specific provisions for LLCs, so bankruptcy courts often look to state laws to decide what to do when such a company files for protection. However, some trends have developed since states began to recognize LLCs as legal entities in the 1980s, even though there are few hard and fast rules.

Dissolution

Depending on whether an LLC has one member or several, a bankruptcy court can elect to treat it as either as a partnership or a corporation. Trustees usually view one-member LLCs as partnerships and pursue liquidation. Assets go to the company’s creditors. Multi-member LLCs fare better. Because the court usually treats them as corporations, members stand in line to receive a share of the company’s assets upon liquidation. Bankruptcy does not discharge or erase an LLC’s debts. The LLC, or the debtor, ceases to exist, but not the debts. An LLC is not permitted to continue in existence and reorganize under a Chapter 13 plan; its only option is a Chapter 7 filing. Chapter 11 reorganizations apply to larger corporations.

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Consent of Members

A Chapter 7 petition filed by a multi-member LLC generally cannot proceed unless all members agree to the bankruptcy. An exception may exist when one or two members exclusively oversee management of the company according to specific language in its agreement.

Effect on Members

Although multiple members of LLCs may be treated as shareholders and receive a portion of a bankrupt company’s assets, this generally does not hold true if any of them have personally guaranteed the company’s debts. A trustee or the company’s creditors may then look to them for payment of the debts, even after the LLC ceases to exist. The member or members of most smaller and single-member LLCs usually guarantee the company’s debts and are liable for them.

Members’ Personal Bankruptcy

In the event that a member has guaranteed company loans and debts, he has the option of filing for personal bankruptcy protection, rather than a company bankruptcy. He can then discharge the debts. Even when a member has not made any guarantees, if his personal finances hit an insurmountable snag and he files for personal protection, the LLC is generally not vulnerable to liquidation to satisfy his personal debts. All members would have to agree to transfer the bankrupt member’s interest to a creditor, which is not likely to occur. In some cases, however, the creditor might receive the member’s distribution payments in recompense for his debts. When a personal debtor is the only member of his LLC, the bankruptcy courts in some states view the LLC as the debtor’s asset, subject to liquidation to satisfy creditors.

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LLC & Bankruptcy

References

Related articles

Can I Be Involved in an LLC & File Bankruptcy?

A limited liability company is a business hybrid -- part corporation, part partnership -- that is set up according to state law. The income of the LLC passes to the members for tax purposes, while federal bankruptcy law applies to any member that files for bankruptcy protection. In this case, the member's interest in the LLC may become an important issue for the bankruptcy court to decide.

Can a Startup LLC Assume Sole Propiertor Debts & Assets?

A sole proprietor who wants to transfer assets and debts to a newly-formed limited liability company, or LLC, can ordinarily do so, but only under certain circumstances. The transactions will be governed by the state law that authorized the formation of the LLC and any agreements between owners restricting capital contributions or withdrawals that change ownership interests. If you are converting a sole proprietor business into a single-owner LLC, you have a lot of leeway to determine how you capitalize your interest in the new company, but you must account for asset transfers properly for state and federal income tax purposes.

The Pros & Cons of LLCs

An LLC, or limited liability company, is a relatively new form of business entity that is a hybrid between a corporation and partnership. The major benefit of an LLC is that is provides its owners -- called members -- with the advantages of both a corporation and partnership, while avoiding the disadvantages of each. However, depending on the needs of your business, there are also disadvantages to the LLC structure.

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