Kentucky Limited Liability Corporations & Bankruptcy

Kentucky Limited Liability Corporations are Only an Asset of the Members

For tax purposes, the Limited Liability Company LLC is treated for financial reporting purposes just as a proprietorship. The LLC offers the everyday small business the best of all worlds

  1. Control.
  2. Limited liability.
  3. Pass-through taxation.

However, in Bankruptcy, the Limited Liability Corporation is not a proprietorship. LLCs were not popular until after 1992, and initially, states did not allow single-member LLCs. An LLC is an asset that belongs to the owner or owners of the LLC. An LLC acts like other corporations. But because members can bind the corporation, an LLC lacks continuity and transferability.

If the sole owner of a Limited Liability Corporation files Bankruptcy, the company is just an asset of the sole owner. The member’s interest in the LLC transfers to the Trustee in Bankruptcy.  The Trustee can then sell the company or assets of the company.

⎆ What if there are multiple LLC members?

If there are multiple LLC members, the assets and the corporation which is jointly owned can generally not be touched by the Bankruptcy Trustee. One member cannot unilaterally dissolve and sell off an LLC when there are multiple members. The same rule applies to the Trustee, who could become the owner of his economic interest, but that interest may not have any benefit. The Trustee also usually is not allowed any governance or decision-making rights under state law for a multi-member LLC. However, some cases have allowed a Trustee some management decision-making.

⎆ If a Kentucky sole member limited liability corporation files bankruptcy, the individual owner did not file.

Kentucky Limited Liability Corporations & Bankruptcy
Kentucky Limited Liability Corporations & Bankruptcy

Some people and creditors believe that if the LLC files a bankruptcy, the person who solely owned the LLC has filed. That is just not the case. The LLC and the owner are separate entities.  Just because the business filed Bankruptcy does not mean that the owner has filed Bankruptcy. Often creditors will not pursue the owner of the LLC if the LLC has filed Bankruptcy. Also, if the owner files Bankruptcy, creditors often will not pursue the business.

Why is this important? Well, the individual member owns the corporation and its assets. The LLC never owns the shareholders and their assets.  If the LLC files a Chapter 7 or 11 bankruptcy, the corporation owner may have substantial assets and still keep their assets. If the LLC files Chapter 7, 13, or Chapter 11, the owner only keeps the exempted property an individual is allowed to keep to start over. When an LLC files Bankruptcy, it keeps none of its property unless the business continues operations under Chapter 11. When an LLC files as a Chapter 7, assets are sold off, and it usually ceases operations.

⎆ Why not file as a Chapter 11.

About 96% of all companies that file Chapter 11  eventually convert it to a Chapter 7 and liquidate. LLCs and Corporations cannot file as a Chapter 13. Only consumers can file Chapter 13. Businesses can only file as a Chapter 7 or an 11. Almost all small businesses eventually fail in Chapter 11. Most cases are best filed as a Chapter 7 for the business, or as a Chapter 13 for the business owner.

The Uniform Limited Liability Company Act in 2006 had sections that helped expand the protections where the right to govern the business stayed in the control of the individual members and most articles of incorporation limit and provide for anti-alienation and transfer of control. Well drafted LLC agreements do not allow control to be alienated and taken over by a bankruptcy Trustee. Which is a reason not to use a young, low-cost lawyer to draft your LLC.

⎆ Conclusion for Kentucky limited liability corporations and bankruptcy.

Bankruptcy Trustees and Creditors can take charge of a member’s rights in a sole member LLC by using a charging order. These charging orders act like any other lien on property, and the charging order can transfer all of the assets and control for a single member. It can also sell the interest of one member to another member in some cases. Or it can take over the distribution of the profits, which would have gone to that member like a paycheck is garnished.

The rights of a trustee are broad because the definition of assets of the estate is broad. When the individual files bankruptcy, he transfers his governance rights as well as his economic interest. If the LLC was a sole member LLC, he holds the entire bundle of LLC rights in the corporation. In a multi-member LLC, the articles control the LLC, and the articles almost always include how governing rights cannot be transferred. Generally, the members choose their partners and membership. That rarely includes a bankruptcy trustee as a business partner.  If you are filing a bankruptcy with the Kentucky Bankruptcy court  for a small business come see us.

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If you are thinking about filing bankruptcy, don’t delay because timing is crucial. I am here to help you. So, contact my office right away to start the conversation. Nick C. Thompson, Bankruptcy Lawyer: 502-625-0905.

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