Limited Liability Company (LLC) Issues in Bankruptcy

A limited liability company is commonly referred to as an "LLC". There are no limitations in New York on the number of members required to form an LLC — it can consist of only one member. The number of members can significantly affect how an LLC fares in a Chapter 7 filing. An LLC is formed by filing Articles of Organization with the NYS Department of State, and its governance is typically set forth in an Operating Agreement. An LLC is a separate legal entity from its individual members, and as such it can file a Chapter 7 or Chapter 11 bankruptcy in its own name. However, an LLC cannot receive a Chapter 7 Discharge, and is not authorized to file a case under Chapter 13.

Unlike partnerships, the bankruptcy filing of a member of a New York LLC does not mandate that the LLC be dissolved or that its affairs be wound up, unless the Operating Agreement calls for such action. In addition, members of an LLC are not personally liable for debts of the LLC, unless the member signed a personal guarantee in connection therewith, or the Operating Agreement so provides.

Under New York law a member's interest in an LLC is classified as personal property, although said individual member has no ownership interest whatsoever in specific property owned by the LLC. Creditors of an individual member cannot collect their debt against LLC-owned property. Consequently, if an LLC member files a Chapter 7 bankruptcy the Trustee appointed in said individual case cannot seize or sell specific LLC property, nor can said Trustee participate in LLC management decisions (assuming it is not a single member LLC). The member's Trustee does succeed to the debtor's pre-petition "economic interest" in the LLC, resulting in the bankruptcy estate being entitled to receive the profits and income stream which flow from said interest. A threshold question in determining the extent of a Trustees' rights in a debtor's LLC membership interest is whether there are other members with an interest in the LLC.

Debtor as sole member of LLC

While there is not an abundance of case law in this area, if the sole member of an LLC files a Chapter 7 bankruptcy, it appears that the debtor's Chapter 7 Trustee can place the LLC in bankruptcy, since there are no other members whose interests require protection. Practically speaking, this will only occur if the LLC has a significant net worth, meaning that the liquidation value of the LLC's assets significantly exceeds the amount of its debt. The "game plan" and hope behind such an action would be that after the Trustee in the LLC case liquidated all LLC assets and paid off all LLC debts there would be surplus funds remaining, which would spill over into the debtor's individual Chapter 7 case, thereby creating funds for a distribution in said case.

Debtor's interest in a multi-member LLC

The debtor's interest in the LLC is personal property and, as such, is an asset that the debtor's Trustee can liquidate, if he can find a buyer. It is not uncommon for a Trustee to sell an interest in a multi-member LLC to one of the other members. The purchaser of said interest clearly is entitled to the debtor's "economic interest" in the LLC, but it appears that under New York law the purchaser only becomes entitled to participate in LLC management decisions if a majority of the other members authorize it.

As with partnerships and Sub-Chapter S corporations, the filing of a Chapter 7 bankruptcy by the LLC itself can have income tax consequences for the individual members if the Trustee is successful in selling LLC assets. The income generated from such a Trustee sale may be taxable to the individual members and not to the bankruptcy estate, since an LLC is a "pass through" tax entity that does not pay income taxes, and the bankruptcy estate generally assumes the taxpayer status of the debtor.

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