Follow Up To LLC Part 1: Getting that other LLC Member

Last week one of the readers left me a comment asking me whether or not he could use his spouse as the minority partner.  Here was my comment:

Generally the best way to avoid losing charging order protection is to get another member.  Because you do not want to lose control, it is best that you give that member a very small portion of the LLC.   I will write a post on this later, but most states give the LLC members a great deal of flexibility.  The California LLC Act allows members to break free from the California LLC Act’s standards by writing into an operating agreement the way the members want the LLC to operate.  This means you can make the call.  You get to write this operating agreement in a way that benefits you as the primary member.   If the other member has 5% or less, and decisions are made by a 65% member or manager vote, (corporate super majority) then you really can run the LLC on your own terms. You need to make sure you address two things however.  

1. Either you need to also write into the operating agreement that the members holding 65% or more do not need to notify the other members to make these decisions, or you need to always call some sort of phone or other meeting when you are making decisions that would generally require a meeting of the members or managers.  It is always good to show that you are following what is in the operating agreement.
2. Second, if you have another member, the money has to be split their way also.  Make sure you assess the tax consequences and necessity of giving that member his portion of distributions if you distribute money out.

A spouse is not a good option for a junior member. The point is to distribute the injury of having an unwanted member in a bankruptcy suit. You and your wife are considered one.

Definition of an LLC: Part-1 The Single Member Hitch

Especially useful for small business owners, the LLC can mold to almost any business model.  Most of the concepts explained below are better explained in the STARTright videos available in your member account.  Limited Liability Companies mesh the best parts of the corporation and partnership.     

Like anything, an LLC is weak when used in ways it was not intended.  I am writing a series of blog entries addressing best practices when using an LLC.  As always, I will follow the STARTright philosophy and try and convey basic concepts using visual diagrams.  This allows you the business owner to make the right decisions.  

Today, lets talk about single member LLCs. Unlike partnerships or corporations, the limited liability company provides two directions of protection.  

• The corporate veil protection: The veil protects the members personal life if the LLC is sued.

LLC has Corporate Veil Protection

• The partnership / charging order protection: The charging order protects the company and the member’s investment if one of the members is sued in his or her personal life.

 

LLCs receive Partnership Charging Order Protection

Single member LLCs are potentially weak if the owner is hoping to protect the LLC if he gets sued himself.  I say potentially, because in law everything is a matter of a two step analysis:

1. Initial Philosophy: laws are usually created to meet a societal need.   
2. Evolving Trends: After a law is introduced, the courts assess whether to change the original interpretation of the law to meet evolving societal needs. 

The original charging order philosophy protected guys A, B from having to accept D as an unwanted partner if C, the person they originally went into business with gets sued.  They don’t want to have to deal with D.  

 

LLC charging order protection intended to stop unwanted partner.

To prevent this unwanted member scenario as shown in figure 3, the charging order is all D can get out of C’s membership as shown in figure 2 above.  The charging order limits D.  He must wait for A and B to decide to distribute money.  No distributions = no money. 

The Single Member Hitch: When a the member of a single member LLC is sued, there is no other members to protect from D.

 

LLC has no one else to protect.

Two bankruptcy courts have used this flaw in the LLC protection to allow creditors of a business owner to completely take over his LLC and liquidate it for cash.  The first case was in Colorado and the nation held its breath to see what would happen next.  The next case was in Idaho and actually used the Colorado case to base its decision on.  This means the trend is starting to move in the direction of denying charging order protection to single member LLCs.  The two cases are linked in pdf format below.  Next I will talk about how a single member LLC owner can remedy this problem.

Albriet: Colorado Bankruptcy Case

A-Z Electronics: Idaho Bankruptcy Case