By: Dean A. Langdon
Many small business owners form limited liability companies (LLC’s) for liability and tax reasons. And Kentucky courts have made it clear that an LLC with only one member is a separate legal entity. Therefore, debts of the LLC are not debts of the owner. Pannell v. Shannon, Ky., 425 S.W.3d 58 (2014). So, if the one member of an LLC needs to file personal bankruptcy, it shouldn’t effect the LLC itself, since it is legally distinct, right?
Not so fast. While a bankruptcy filing by the single member of an LLC doesn’t put the LLC into bankruptcy, it can have unintended consequences. When an individual files bankruptcy, virtually all of his or her property rights come under the control of the bankruptcy court. The assets are then administered by a trustee. So, if a debtor owns 10 shares of stock in Amazon, a bankruptcy trustee will have the right to sell that stock and pay the proceeds to creditors. They can do this unless it is claimed exempt. With a single-member LLC, there usually isn’t any market for the debtor’s membership interest, so a trustee may not do anything with the LLC. Unlike a share of stock, a membership interest in a single-member LLC usually includes a right to control the LLC.
So, if you are the only member of an LLC and file bankruptcy, the trustee could exercise your right to control the LLC. This happened in a bankruptcy case in Louisville, Kentucky where a sole member filed an individual chapter 7 bankruptcy. His trustee asked the bankruptcy court to authorize the sale of real property the LLC owned. The debtor listed his membership interest in the LLC as asset and valued it at $50,000. However, he did not claim any of the value as exempt. They also objected to the trustee’s request, but the bankruptcy court allowed the sale. They allowed it because the trustee had the same rights as the debtor did. They could decide if the LLC should sell its assets.
There was an appeal filed by the debtor to the bankruptcy appellate panel of the Sixth Circuit, which was dismissed. In re Pasley, Case No. 18-8048 (B.A.P. 6th Cir. August 6, 2019). The B.A.P. found that the debtor didn’t have standing to appeal because once he filed bankruptcy, the sale of the LLC’s property didn’t affect his pecuniary rights. In other words, since the debtor didn’t claim an exemption in his membership interest in the LLC, the only way the sale of its assets would ever benefit him was if the sale proceeds paid all of the LLC’s creditors, then all of the debtor’s creditors. Only then would the sale have a potential impact on the debtor. And, it was up to the debtor to show that such a result might be possible.
Lessons learned are that you should a) be prepared to lose control of a single-member LLC if you file bankruptcy; b) have a clear understanding of the debts and assets of the LLC. Then evaluate whether the sale of its assets might generate money above its debts; c) claim any available exemption in the LLC; or d) be prepared to show the court that you might recover as the owner of the LLC after all of its debts, and your, are paid. This is one of many issues DelCotto Law Group deals with on a frequent basis. DLG’s goal is to help small business owners deal with financial distress.
About DelCotto Law Group
DelCotto Law Group is Kentucky’s asset protection law firm known for its commitment to the lifetime success of its clients. With offices located in Lexington, Louisville and Danville, DLG serves Kentuckians with complicated financial matters, especially in the areas of bankruptcy, complex litigation, and estate planning. For more information about filing bankruptcy or DelCotto Law Group, please call (859) 231-5800, email [email protected] or reach us on our contact page.