Why LLCs are so Darn Attractive
Engaging Entrepreneur (“EE”) comes into a lawyer’s office with a well thought out business plan and has the capital to get the business started. EE is concerned the business could fail – as many do during the first three years – or something could happen that could jeopardize EE’s ownership or control over the company. EE knows the best way to protect herself is to incorporate. The lawyer advises EE to set up a limited liability company (“LLC”). But why an LLC?
An LLC has the same advantages as a corporation. It shields its officers and managers from personal liability. And although there are exceptions to such protections such as when an officer engages in fraud or is involved in self-dealing, they should not concern an honest and diligent person. EE gives up the shield of the LLC by personally guaranteeing the debt of the LLC to various vendors in order to secure company credit. When the LLC experiences solvency problems, EE remains personally liable. It is at this point EE is going to reap the benefits an LLC has over a corporation.
Three months after the LLC defaults in paying various creditors, one of the creditors comes to your office looking to collect against EE on the personal guarantee. The vendor hires you. You make demand, then sue, and then obtain a judgment. The judgment goes unpaid. You make plans to engage in post-judgment enforcement. You determine the LLC owns a valuable piece of real estate that owes very little on the mortgage. So now you are thinking EE’s ownership interest in the LLC can be seized and sold or controlled through post-judgment measures. Think again!
Your plan of action would be correct If EE’s’ lawyer had chosen a regular corporation as the entity under which to form the business. After all, EE’s ownership interest is her personal asset. In that scenario you could go into court and get EE’s ownership interest turned over to a receiver who could take control of the company and/or sell its assets. However, you are dealing with an LLC. What can a judgment creditor do to take control over the LLC? Almost nothing. It has one judgment enforcement tool only against the LLC: a charging order.
A charging order requires the LLC to pay any distributions (profits/dividends) to your judgment creditor which would, otherwise, be paid to EE for so long as the judgment remains unpaid. It sounds reasonable but is often an ineffective remedy. In particular, EE remains in control of the LLC. EE cannot be forced to sell this valuable real estate. EE’s control over the LLC allows her to do a number of things, including: not make a distribution; increase the entrepreneur’s salary; claim personal expenditures as company expenditures. There is no legal requirement that an LLC makes a distribution. Salaries are often artificially low. Bringing them up to market rates is not only legal but appropriate. Paying personal expenses is illegal but hard to discover. LLCs are rarely required to provide an accounting to a judgment creditor. It usually requires a separate motion and proof of manipulation of the company to get a judge to order an accounting.
Charging orders are more effective when there are at least three members and the other members want to realize the profits of the business and to make distributions. The other members will not agree to manipulate distributions, normally, because they do not want to expose themselves to liability for such illegal conduct.
Even if EE is willing to sell the real estate to pay the judgment, EE is in control. It provides EE real peace of mind to know no one is going to come in unannounced and take over EE’s control of the LLC. It allows EE to have continuity in the LLC and keeps EE in control of when and how its creditors are paid. And that is power: power one cannot exercise when operating as a corporation.