90-Second Lesson: Personal Chapter 7 Bankruptcy Petition, Are Single-Member LLC Assets Safe from the Trustee?

QUESTION:

Bob Business Owner wants to know: if he files Chapter 7, can the Chapter 7 bankruptcy trustee reach the assets of his single-member LLC to satisfy his personal debts?

ANSWER:

A main attraction of limited liability companies (LLCs) is their ability to provide a layer of protection between the owners’ personal assets and the company’s liabilities. Typically, if an LLC is sued or obligated in another way, the owners of that LLC are generally not personally liable for the LLC’s obligations.

But this is not responsive to the question. Rather, Bob’s question assumes that the LLC of which Bob is the 100% member is doing just fine. It is Bob, personally, whose finances are bad. And so, for reasons having nothing to do with the LLC, he is thinking about filing for personal Chapter 7.

If Bob files Chapter 7 bankruptcy, his non-exempt assets are subject to liquidation (sale) by the Chapter 7 trustee. In return, Bob will get a discharge from his debts

• except for those debts that are not dischargeable and
• unless Bob’s actions have caused him to lose his right to a discharge.

Upon the filing of a Chapter 7 petition, a Chapter 7 estate is formed consisting of all the debtor’s non-exempt property, and the debtor’s membership interest in his LLC is certainly an example of non-exempt property under every state’s law, therefore, would be the property of the debtor’s estate.

Thus, the Chapter 7 trustee will own the LLC membership interest. A mere ownership interest in an LLC, however, is not the same thing as owning the assets of the LLC. The LLC assets were not property of the member and thus will not be property of the member’s Chapter 7 estate.

An LLC, in most states, may be member-managed or manager-managed.

A member-managed LLC is one in which each member participates in management by voting on management decisions and actions. In a single-member, member-managed LLC, that sole 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 (net of paying creditors of the LLC) assets would ultimately be distributed to pay the member’s creditors.

A manager-managed LLC is one in which the members of an LLC designate one or more people (or entities) as its manager(s).

Most single-member LLCs that are manager-managed select the sole member as 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 most state’s law and, therefore, 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 it, can nevertheless replace the manager. A prudent Chapter 7 Trustee would not delay in doing this if there are any assets in the LLC.

Once the Trustee becomes manager of the LLC, they can then act to dissolve and wind up the LLC or otherwise take action to make the LLC’s assets or cash flow available to pay the member’s personal creditors (after payment of the LLC’s creditors).

Ultimately, therefore, in most situations, a single-member LLC’s value will be reachable by a Chapter 7 trustee to pay Bob’s creditors.¹

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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.

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[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can view at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Buying a Business 101 – 2022
2. The Intersection of Bankruptcy and…Tax Law 2020
3. The Very Basics: Forming the Business 2022

This is an updated version of an article originally published on May 24, 2019. It was edited by Joseph Wittman, Esq.]

©2022. DailyDAC^TM, LLC d/b/a/ Financial Poise^TM. This article is subject to the disclaimers found here.

1. This discussion assumes there is no other basis by which a Chapter 7 trustee can properly attack the assets of the LLC. Specifically, for example, it does not consider the possibility that Bob could have transferred personal assets into the LLC before filing for a bankruptcy, in which case the trustee can seek to avoid such transfer as a fraudulent transfer. Please check the laws in your state to determine whether the outcome would be similar.