April 13, 2021
Limited Liability Companies: Drafting for Bottom-Up and Top-Down Liability
In this article, Mr. Dickey and Mr. Beasley address the use of limited liability companies (“LLC”) in estate planning and asset protection and important drafting tips for LLC governing documents to keep property beyond the reach of creditors.
LLCs are best known for the favorable characteristics they take from the other types of entities. In the most rudimentary sense, LLCs can combine the favorable liability protection from corporations with the often favorable tax treatment from partnerships.
LLCs are known as “pass through entities” meaning all of the profits and losses of the LLC pass through the business to the owners of the LLC, or “members.” The LLC itself does not pay federal income tax. If the LLC elects to be taxed as a partnership, the LLC will issue a Form 1065 K-1 to its members showing that member’s lawful share of the LLC’s profits and losses. The members then report this information on their individual tax returns. It is important to note that the LLC is not required to distribute profits to its members. How distributions are handled is typically set out in the LLC’s governing document, or operating agreement. Even if the LLC does not distribute the profits to its members, the members will be taxed on their share of those profits. This fact will become important later in the article in regards to charging orders.
Bottom-Up Protection. LLCs, like corporations, are legal entities, separate and distinct from the individuals who create and own them. In that regard, just like the shareholders of a corporation cannot generally be held liable for the obligations of the corporation, the members of an LLC cannot generally be held liable for the obligations of the LLC. There are obviously some exceptions to this general rule. First, like the shareholder of a corporation, a member of an LLC will be liable up to the amount of his or her investment in the LLC. Thus, any capital or property the member transfers to the LLC in exchange for his or her ownership stake in the LLC or “membership units” (similar to shares of stock of a corporation) is an asset of the LLC and therefore can be used to satisfy the claims of its creditors. Another exception to the general rule, is when the members of the LLC do not observe the formalities of the entity and the formal separation between themselves and the entity, or the members commit fraud on the LLC’s creditors. In these situations, a court could “pierce the corporate veil” and impose personal liability on the individual members. However, assuming the members refrain from these kind of activities, the liability to creditors of the LLC is generally limited to the assets of the LLC. This concept of protecting the members of the LLC from personal liability to the creditors of the LLC is known as “bottom-up” liability protection; in other words, the creditors cannot go above the entity to the owners to seek satisfaction of their claims.
Let us consider the example of an LLC that is the record title holder of a rental house. Let us assume that Dick and Jane Members, a married couple, owned the house jointly, and each transferred their respective interest in the rental house to the LLC in exchange for 50% of the membership units of the LLC. Now, let us assume that a guest of the tenant of the rental house was injured due to some construction defect of the rental house. The only asset owned by the LLC is the rental house which has a fair market value of $150,000. Dick and Jane both have personal assets outside of their respective LLC interest in excess of $1,000,000 each. If the guest sues the LLC for his injury and is awarded a judgment of $500,000, he may very well be able to levy on the rental house itself because it is an asset of the LLC. However, assuming Dick and Jane have not committed any of the kind of actions mentioned above, the guest plaintiff should not be able to go above the assets of the LLC to reach Dick and Jane’s personal wealth. This is referred to as “bottom-up” protection.
Top-Down Protection. Most people understand the concept of bottom-up protection, which is why so many people form LLCs. However, consider the following example. Let us assume that Dick is the sole member (100% owner) of an LLC that owns the same rental house described in the example above. Dick’s personal wealth outside of the LLC interest is roughly $1,000,000. Dick accidently lets his car insurance lapse and subsequently runs a red light, injuring another driver. Driver sues Dick and is awarded a judgment in excess of $1,000,000. Can plaintiff driver levy on the rental house in an attempt to satisfy his judgment even though the LLC is the record title holder of the rental house? In other words, does Dick have “top-down” protection, preventing the creditor from levying on the LLC’s assets to satisfy his personal debt?
In a case out of Florida, Olmstead v. FTC, the Florida Supreme Court held that the provision of the Florida Limited Liability Company Act providing a judgment creditor with the right to a “charging order” against the judgment debtor’s ownership interest in a single-member LLC was not intended to be an exclusive remedy and that the judgment creditor may pursue the standard remedy of levy and sale of the LLC’s underlying assets upon execution. On the other hand, a charging order is an order issued by a court directing an LLC’s manager to pay to the debtor member’s personal creditor distributions of income or profits, if any, that would otherwise be distributed to the debtor member. In coming to this decision the court reasoned that the charging-order provision must be understood within the context of the basic rule under Florida law that an assignee of an LLC interest (i.e. a creditor) may only become a member if all members other than the member assigning the interest consent.
The limitation on assignee rights [under the Florida statute] has no application to the transfer of rights in a single-member LLC. In such an entity, the set of ‘all members other than the member assigning the interest’ is empty. Accordingly, an assignee of the membership interest of the sole member in a single-member LLC becomes a member—and takes the full right, title, and interest of the transferor—without the consent of anyone other than the transferor.
Because the judgment creditor becomes a member and takes the sole member’s full rights, title and interest, he too takes the right to manage the LLC and to liquidate it and have access to the underlying assets. To that point, the court held:
[s]ection 608.433(4)'s provision that a ‘judgment creditor has only the rights of an assignee of [an LLC] interest’ simply acknowledges that a judgment creditor cannot defeat the rights of nondebtor members of an LLC to withhold consent to the transfer of management rights. The provision does not, however, support an interpretation which gives a judgment creditor of the sole owner of an LLC less extensive rights than the rights that are freely assignable by the judgment debtor.
After the Olmstead decision, the Florida Legislature later revised the statute to make clear that “a charging order is the sole and exclusive remedy by which a judgment creditor of a member . . . may satisfy a judgment from the judgment debtor’s interest in a limited liability company or rights to distributions from the limited liability company” for multiple-member LLCs. § 605.0503(3), Fla. Stat. (2014). Again, this is because the consent of all members is required for the admission of a new member (i.e. a creditor). The revised statute did, however, preserve the court’s holding in regards to single member LLCs.
Why is this case from Florida relevant? Because it is conceivable that a Georgia court could reach the same conclusion. The relevant Georgia statute is O.C.G.A. § 14-11-504, which, before a 2009 amendment, stated:
(a) On application to a court of competent jurisdiction by any judgment creditor of a member or of any assignee of a member, the court may charge the limited liability company interest of the member or such assignee with payment [from the debtor member’s share of income distributions, if any] of the unsatisfied amount of the judgment with interest. To the extent so charged, the judgment creditor has only the rights of an assignee of the limited liability company interest [to receive any such distributions]. This chapter does not deprive any member of the benefit of any exemption laws applicable to his or her limited liability company interest.(b) The remedy conferred by this Code section shall not be deemed exclusive of others which may exist, including, without limitation, the right of a judgment creditor to reach the limited liability company interest of the member by process of garnishment served on the limited liability company.
(Bracketed information added). A court could easily apply the same equitable logic to the Georgia statute which also provides that consent of all the members of the LLC is needed to admit a new member to the LLC. But, when the only member is the judgment debtor, there are no other members who have to consent to the creditor becoming a member. And, if a court finds that a single member judgment debtor assigns all of his rights and interests in the LLC to his creditor, then it logically follows that said debtor also assigns his right to manage and to liquidate the LLC. If such a decision were reached, then there is nothing to stop the judgment creditor, as the sole member and manager of the LLC, from forcing a liquidation sale of the LLC assets in order to satisfy his or her judgment.
The 2009 amendment to the statute may make such a decision less likely. The following proviso (the “proviso”) was added to the end of subsection (b) quoted above:
[E]xcept as otherwise provided in the articles of organization or a written operating agreement, a judgment creditor shall have no right under this chapter or any other state law to interfere with the management or force dissolution of a limited liability company or to seek an order of the court requiring a foreclosure sale of the limited liability company interest [nor would it allow the sale of the underlying assets of the LLC].
O.C.G.A. § 14-11-504(b)(bracketed information added). However, although the proviso expressly gives the judgment creditor no right to interfere with management or force a foreclosure sale, it does not specifically address the situation described above – that a court could find in single-member LLC cases that the judgment creditor takes all of the rights (including management rights) of the single member debtor. The bottom line is, without case law interpreting the proviso, a judgment creditor in Georgia may still have an argument as to why he or she can levy on the underlying assets or the membership units of a single-member LLC.
Thus, in order to ensure “top-down” protection, it is a good idea in Georgia to have more than one member in an LLC. If the LLC is a multi-member LLC, then the reasoning from Olmstead is moot. O.C.G.A. § 14-11-308(b) states that unless otherwise provided in the articles of organization or a written operating agreement, the unanimous vote of the members is required to approve the following non-exhaustive list: dissolution of the LLC; the sale of all or substantially all of the assets of the LLC; and the admission of new members. In the case of a multi-member LLC, one member (irrespective of how small of an interest such member owns) can prevent a judgment creditor from becoming a member, selling the assets of the LLC or dissolving the company. This is a very powerful tool for top-down protection. It is important to note however, that the terms of § 14-11-308(b) can be altered by a written operating agreement. Therefore, when drafting an operating agreement for top-down protection, it is good practice to require unanimous consent for such matters. Even without 14-11-308(b), however, multi-member LLCs would likely still be protected from judgment creditors under the proviso of 14-11-504(b). Customized drafting could prove critical in the asset protection arena.
There are some drawbacks to forming a multi-member LLC. Unlike single-member LLCs, Multi-member LLCs must file a separate tax return. Again, the LLC does not pay federal taxes, but a separate return must be filed and K-1s issued to the members if the LLC elects to be taxed as a partnership for federal tax purposes. This obviously adds extra administrative expense to the LLC, but, when considering the top-down protection it adds, it should be well worth it.
The manner in which LLC members are taxed also provides a very powerful tool in protecting assets of the LLC. As was mentioned above, O.C.G.A. § 14-11-504(a) gives a court the right to issue a charging order in favor of the judgment creditor to charge the LLC interest of the judgment debtor with payment of the unsatisfied amount from distributions, if any, made to the member. In other words, the creditor, who is awarded a charging order, is entitled to the judgment debtor’s distributions from the LLC. However, if the operating agreement is carefully drafted, the management of the LLC may not be required to make distributions to the members. From the proviso, we know that at least in the case of a multi-member LLC, a judgment creditor has no right to interfere with management. Therefore, the creditor cannot force a distribution to the members if the operating agreement gives management or all members the power to declare distributions. And, as was mentioned above, the LLC will issue a Form 1065 K-1 to its members showing each member’s lawful share of the LLC’s profits and losses. The members must report this information on their individual tax returns. This is the case whether or not the LLC distributes the profits to the members. Thus, imagine the situation where management of an LLC decides not to make any distributions of the profits, but the LLC issues a K-1 to a judgment creditor showing his or her share of the profits. The judgment creditor must report the profits on his or her individual return and pay income tax on such amount. Therefore, the judgment creditor may very well think twice before seeking a charging order if all it will render is an income tax bill with no accompanying distributions to pay it. Again, this can be a very powerful tool, assuming the operating agreement is drafted in such a way that the management has discretion over the distributions (or all members, including any relatives in the debtor’s family who are also members of the LLC, must approve any distributions of profits).
LLCs can be powerful business and estate planning tools to provide bottom-up and top-down protection of assets. However, when using LLCs for liability protection, one should consider the pitfalls that exist if the LLC is formed a certain way (single member versus multi member) or if the governing document of the LLC is not carefully custom drafted. Bottom line: one should seek the advice and service of an experienced business attorney when considering the possibility of forming an LLC.
David H. Dickey is a partner at Oliver Maner LLP and concentrates his practice in the areas of Estate Planning, Business Law, Business Entities, Probate & Estate Administration and Taxation. He can be reached by email at firstname.lastname@example.org and by phone at 912.236.3311.
Ryan Beasley is an associate at Oliver Maner LLP and concentrates his practice in the areas of Estate Planning, Business Law, Business Entities, Probate & Estate Administration and Taxation. He can be reached at email@example.com and by phone at 912.236.3311.