A small business owner emailed us, on behalf of a friend, to ask whether assets in a single-member LLC could be used by a Chapter 7 Trustee in the LLC member’s personal bankruptcy case to satisfy creditors’ claims against the member.
We can imagine this question arising where the member’s business is owned by an LLC of which he is the sole member. Let us suppose that the LLC member (not the LLC) has been sued for an amount that dwarfs his modest non-exempt personal holdings and that he is about to lose that lawsuit and have a large judgment entered against him. He could go into a chapter 7 bankruptcy, have his modest non-exempt personal holdings liquidated to pay creditors (including the potential large judgment holder) and receive a discharge from his debts. But could the Chapter 7 Trustee, who will have custody of all non-exempt property, get to the assets of the single-member LLC? In Illinois, the answer is likely “yes.”
We should first note that if the member had transferred personal assets into the LLC within one year before the bankruptcy case, the Trustee could seek to avoid and recover the transfer for the estate as a preferential transfer to an insider under the Bankruptcy Code. If the member made the transfer over the 4 years prior to the bankruptcy case (in Illinois), the Trustee could avoid and recover the transfer as a fraudulent transfer, under the Bankruptcy Code and under state fraudulent transfer laws which the Trustee is empowered to use. Of course, there are defenses to these actions.
Let us leave avoidance actions aside. How does the trustee otherwise get to the LLC’s assets? The following discussion relies upon the opinion in In re Campbell, 475 B.R. 622 (Bankr. N.D.Ill. 2012), which took up the issue in the context of LLCs under the Illinois Limited Liability Company Act.
Upon the filing of a Chapter 7 petition, a Chapter 7 estate is formed consisting of all the debtor’s property. The debtor’s ownership interest in an LLC membership is property under state law and constitutes property of the debtor’s estate. Thus, the Trustee now holds and controls the LLC membership interest. OK, but that is not the assets of the LLC. The assets of the LLC are not property of the member and do not automatically become property of the member’s chapter 7 estate.
An Illinois LLC may be member-managed, where each member takes part in management by voting on management decisions and actions. In a single-member, member-managed LLC, that one member decides and acts for the LLC. Upon a chapter 7 bankruptcy, the Trustee holds the membership for the benefit of creditors, and may then act to dissolve and wind-up the LLC, whereupon the assets of the LLC would be liquidated first to pay off LLC creditors and second to be distributed to the member, now the member’s Chapter 7 estate. Thus, the LLC’s net assets would be distributed to pay the member’s creditors.
However, an Illinois LLC may also be manager-managed, where the members of an LLC elect (or remove) a person designated as manager. The single-member manager-managed LLC could (and likely would) select the sole member as its manager. In a Chapter 7 bankruptcy of the LLC member, the LLC membership interest would become part of the Chapter 7 estate, but the ability to be manager would continue to be held by the manager – even if the debtor were the manager. How? The ability to be a manager of a manager-managed LLC is not property under state law and thus cannot become property of the estate.
No counting of chickens, or even of eggs, though. The Trustee would hold the sole membership interest, and with that interest, the Trustee could replace the manager with the Trustee. A prudent Chapter 7 Trustee would not delay in doing this if there are any assets in the LLC. Once the Trustee is elected or appointed manager of the LLC, he or she could act to dissolve and wind-up the LLC, whereupon the assets of the LLC would be liquidated first to pay off LLC creditors and second to be distributed to the LLC member, now the member’s Chapter 7 estate. Thus, the LLC’s net assets would be distributed to pay the member’s creditors.
[Editors’ Note: this is part of our irregular series in which we answer readers’ questions. If you have a question, submit it to [email protected] and we will try to answer it.]
[Editor’s Note: You may also be interested in Anatomy of a Preference Action.]
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