Can I Be Involved in an LLC & File Bankruptcy?

By Tom Streissguth

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.

Winding Up the Business

State law governs limited liability companies and what happens in case of a member bankruptcy. In Pennsylvania, for example, an LLC must dissolve when a member declares bankruptcy, unless the operating agreement provides otherwise or a majority vote of the members decides that the company will remain in business. However, by some court decisions, a provision in the federal bankruptcy code known as Section 541 transfers a debtor's rights in an LLC to the bankruptcy estate.

Economic and Management Rights

State laws also allow members to assign their share in the LLC to another party, whether a bankruptcy has taken place or not. Any such transfer must conform to the rules in the operating agreement. In addition, bankruptcy courts will generally allow debtors in bankruptcy to transfer these "economic rights" without the consent of "non-debtor" members. The "management right" of the member to govern or vote within the LLC is another matter; state laws will generally not allow a transfer of management rights to a third party if the other LLC members do not agree.

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Single-Member Bankruptcy

Nothing in the law prevents an individual from filing for bankruptcy protection if he's also a member of an LLC. However, anyone filing for bankruptcy must list all assets and income sources, including any share they hold in a business. If a single individual manages an LLC, the income he receives from that LLC becomes part of the bankruptcy estate. The bankruptcy court and the trustee would have the authority to dispose of the LLC income as they see fit, although the business assets would remain separate if the LLC itself is not in bankruptcy.

Credit and Collateral

An LLC member is not personally liable for the debts of an LLC unless he provided a personal guarantee or collateral for business loans. By the same token, if he files for individual bankruptcy, his creditors may not claim LLC assets for repayment of their loans. Many LLCs have few or no assets and operate as holding companies for subsidiary businesses. A member bankruptcy does not normally affect the operation of these businesses or income that flows to the other members.

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What Is a Pro Rata Share for an LLC?

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Advantages & Disadvantages of a Single-Member LLC

An LLC enjoys the limited liability of a corporation, and the potential tax benefits of a disregarded entity. State law regulates LLCs and determines whether single-member LLCs are allowed. Single-member LLCs may enjoy tax benefits, and they offer owners a great deal of control. On the other hand, the informality of an LLC may create difficulties when establishing credit. A single-member LLC has the choice to be taxed as a sole proprietorship or corporation.

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