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Limited Liability Company (LLC) Issues in Bankruptcy

Middletown Lawyers Discuss Limited Liability Company (LLC) Issues in New York 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.

Any clause in an Operating Agreement providing for dissolution of an LLC, or termination of the member’s interest, upon said member’s filing of a bankruptcy petition are not enforceable, per 11 USC § 541(c)(1).

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.The Chapter 7 Trustee steps into debtor’s shoes and succeeds to all of the debtor’s pre-petition rights (“economic” as well as “non-economic”) under the Operating Agreement. The Trustee’s rights and powers are limited to those held by the debtor at the time of the filing, and the Trustee is bound by restrictions contained in the Operating Agreement (unless the Operating Agreement is deemed an executory contract and assumed by the Trustee, a scenario that is far beyond the scope of this webpage). Interestingly, unless the Operating Agreement provides to the contrary, New York law allows the Trustee to sell only the debtor’s pre-petition “economic interest” in the LLC, meaning that the purchaser (or assignee) of a debtor’s LLC interest becomes entitled to receive the profits and income stream that flow from said interest, but not the right to participate in the management and running of the LLC (the “non-economic” interests).  A threshold question in determining the extent of a Trustee’s 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

The Chapter 7 Trustee can sell the debtor’s interest in the single member LLC, if a buyer can be found. A single member LLC is not the most effective vehicle to shield assets from creditors. The purchaser would control (but not own) the assets of the LLC. and would have to deal with the LLC’s debts as well.

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.

The Chapter 7 Trustee could also seek a dissolution of the LLC under the Operating Agreement and State law with the “game plan” being the same as above set forth.

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 debtors “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.

The Chapter 7 Trustee can also seek:

  • A dissolution of the LLC pursuant to the provisions of the LLC. but unless the Operating Agreement provides otherwise.New York law requires that a majority of all members approve such an action. Unless the debtor held at least a 51% membership interest, the Trustee will be unable to employ this strategy without the consent of some (or all) of the other members.
  • A judicial dissolution of the LLC. although this remedy is typically reserved for situations where the LLC’s management has become so dysfunctional or its business purpose so thwarted that it is no longer practicable to operate the business. Since a Trustee’s desire to reduce the debtor’s LLC interest to cash is probably inconsistent with the goals of the other members wanting to continue the business operations. this remedy can potentially bear fruit for a Trustee. although the LLC would need to have a positive “net worth” (ie.. value of LLC assets exceeds amount of LLC debt) for it to be worthwhile for the Trustee to pursue.

Potential Income Tax Consequences of a Trustee’s Liquidation of an LLC

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. The bankruptcy estate could end up with the cash from the sale proceeds, with the individual members ending up with the income tax bill generated by the Trustee’s sale. This could easily ruin one’s day.

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