Many of the business owners we talk to at Delancey Street assume the company will go away when they file personal bankruptcy, or that they could lose the LLC. Personal bankruptcy doesn’t automatically trigger the company’s dissolution. On the other hand, the situation will create some serious ramifications for your business, likely ones that you don’t expect. What happens to the LLC then depends on whether there is just one member or more than one, what the company agreement says, and whether the LLC’s value exceeds its liabilities. The rules below come from New York law. In this post, we address some of those potential risks and liabilities.
The Company Keeps Going
The first thing to know is that the company keeps going. Unlike a partnership, a New York LLC generally doesn’t dissolve or wind up when a member files personal bankruptcy. There’s nothing at all magical about personal bankruptcy that forces a company to wind up its affairs. New York makes an exception where the operating agreement calls for it, but federal bankruptcy law (11 U.S.C. § 541(c)(1)) limits even that. For example, a clause might say that the filing of a bankruptcy petition by a member will terminate the member’s interest or dissolve the LLC. Such clause is unenforceable.
Membership Interest
The second thing is that your ownership changes hands, even though the company’s property doesn’t. In plain terms, an LLC is a distinct entity which exists separately from the individual owners (i.e., members) of the LLC. So, you as an individual are not the legal owner of LLC property. The LLC is. A member’s interest in an LLC is considered personal property in New York, but you have no ownership stake in the actual LLC-owned property. As a result, your individual creditors can’t seize the property of your LLC to collect their debts. In a Chapter 7 case, your bankruptcy trustee can’t take control of that property, either. What does change is that the bankruptcy trustee steps into your place and takes over your membership interest. The trustee has the exact same rights that you had before you filed for bankruptcy. That means that the trustee will hold the economic powers that you had under the Operating Agreement of your LLC. The same goes for your non-economic rights, like your vote. On the other hand, he’s subject to any limitations in the Operating Agreement.
The third thing is that the trustee can sell your interest, though usually not all of it. Unless the operating agreement says otherwise, New York law lets the trustee sell only your pre-petition economic interest. This means that the purchaser would only get the right to receive profits and income distributions from the LLC. In other words, they can’t take over your management role and get involved in the day-to-day running of the business.
The fourth thing depends on whether you’re a sole member of the LLC. If you are, your ownership interest can be sold by the Chapter 7 Trustee if there is a buyer. The buyer controls, but does not own the LLC’s assets, and of course must also deal with the LLC’s debts. But you should know, a single member LLC is not the best way to protect your assets from creditors. There isn’t much case law here, but since no other members need protecting, it appears the Trustee can also put the LLC in bankruptcy or dissolve it, but that probably won’t happen unless the LLC’s assets substantially exceed its debts. Either way, it’s a power play that a Trustee can utilize to squeeze more value out of the asset - the LLC - and the idea is to sell off its assets, pay its debts, and hope the surplus spills over into your personal Chapter 7 case, where it can go to your creditors. Neither choice is to your liking.
If you have partners, your interest is still an asset the trustee can liquidate. The Trustee may or may not be able to find a buyer, but one common scenario is that one of your partners will want to buy you out. It appears that a purchaser of an interest in a New York multi-member LLC receives the economic rights associated with the interest, but can only participate in management if the other members agree to admit the new member by a majority vote. The trustee also might ask for a court to shut down the LLC on the grounds that it cannot work any more. That judicial dissolution is typically reserved for those situations where a lack of cooperative action by the members leads to an “unraveling” of the entity, to the point where running the business is no longer practicable. The situation for the trustee then is that your partners don’t want to shut down the business, and that conflict can potentially work in the trustee’s favor, but it’s only worth pursuing if the LLC’s assets are worth more than its debts.
The fifth thing is the one that catches people off guard: taxes. An LLC doesn’t pay any taxes itself. Instead, the income of your LLC is taxed to you. That matters if the LLC itself ends up in a Chapter 7 case, since the bankruptcy estate generally assumes the debtor’s taxpayer status. Then the Bankruptcy Trustee may have the option to sell LLC assets, and the income tax consequences of that sale may pass through to the individual members of the LLC. The bankruptcy estate may end up with the cash from the sale proceeds, and you may be on the hook for the taxes. It’s a bad outcome for you.
None of this changes the basic rule on liability for the company’s debts: you don’t have to pay the LLC’s debts from your personal savings account. This is unless you signed a personal guarantee when you obtained credit for the LLC, in which case your personal savings account could be targeted. The same goes if the operating agreement makes members liable. And because it is a separate entity, the LLC itself could also file a Chapter 7 or 11 case (but not a 13), although it would not be entitled to a Chapter 7 discharge.
Delancey Street is a business debt settlement company, not a law firm. If you are aware that bankruptcy is a possibility, or you’ve already discussed it with an attorney - a scary thought for a small business owner - it’s worth knowing every option before moving forward. Our senior advisors negotiate with merchant cash advance funders, lenders and other creditors for less than the full balance owed. When bankruptcy is the better path, we’ll say so on the first call and refer you to a vetted independent attorney.
