Multi Member LLC s vs Single Member LLCs
When forming an LLC, it is good to know that multi member LLCs offer the best charging order protection. First let me explain the history of charging order protection, and then it is easier to understand the precarious position a single member LLC might end up in.
In Old England the principal business entity was a partnership. In fact, it was basically the only entity possible if a couple of people (or even a lot of people) wanted to collaborate on a business venture. They didn’t have single member and multi member LLCs. The problem was when partner number one got in trouble personally; his creditors could come against the partnership for satisfaction of his debts and liabilities.
The question always is, “how does someone get in trouble personally?” The big one today is the person gets sick. Over 50% of all bankruptcies in the US today are a result of medical issues. You can get divorced. That’s personal not business. You make bad real estate investments outside your principal business. Those are personal investments, and today they’ve probably gone south big time. This leaves you and your LLC vulnerable to creditors and this is why a multi member LLCs are better.
In Old England when partner number one got sick and lost everything, including his partnership interest, the other partners were simply out of luck, because the new creditor literally became a partner and would simply sell the partnership assets. There was nothing the other partners could do to save their business, even though they had done absolutely nothing wrong.
The courts finally decided that having all the partners suffer just because partner number one made a mistake or got sick and had big bills wasn’t fair. So they created a system where the creditors couldn’t take the partnership interest. All they could do was put an “economic lien” on partner one’s interest in the partnership.
Once the creditor got a judgment against partner number one, they then asked the court for an order “charging” partner number one’s partnership interest for the amount of the judgment. Thus, a “charging order.”
If the partnership distributed any profits (or losses) the creditor got the profit instead of having it go to partner number one. But, this protected the other partners, because the creditor couldn’t execute the judgment directly against the partnership assets and couldn’t take over as a partner.
Multi Member LLC Charging Order Attack Justification
In the cases that have attacked charging order protection in a single member LLC, the logic has always been that the intent of the charging order was to protect the “other partners.” In a single member LLC there isn’t any “other partner” or member, so the intent of the charging order protection isn’t able to be fulfilled. You have to have a multi member LLC to justify this protection.
Therefore, the couple of court cases that have gone against the charging order concept have involved single member LLCs. Hence there is now a rise in the multi member LLC. In Florida and Colorado, it is necessary to have more than one member in an LLC to be assured of getting the charging order protection that you want.
It is also necessary to have multiple member LLCs to get charging order protection in Utah, because Utah has passed legislation that prevents a single member LLC from getting any benefit from charging orders.
Multi Member LLC Ownership Percent to Get Charging Order Protection
Technically, any percentage of ownership interests divided up between two or more individuals makes a multi member LLC. So in theory a one percent interest held by a second member in an LLC is enough to make the LLC a “multiple member LLC” instead of a single member LLC.
However, I suggest that the “other member” be given a five percent or more interest in the multi member LLC if you want to be really safe. The courts haven’t ruled on what is enough ownership interest to make a multiple member LLC.
If the courts don’t know, then for sure the IRS does. The IRS considers someone who has a five percent interest or more in a company to be a significant owner of the business. If the “multiple” member LLC status is ever challenged by a court, because one of the owners “only had” a five percent interest, you could certainly point to the IRS position and state that the courts should consider the LLC as a having more than one member, because the IRS would rule that way.
Whether it is a single member LLC or a multiple member LLC, how the operating agreement is written will make a big difference in how practical the charging order protection really is. There are lots of little tricks and poison pills that can be inserted into the language of an LLC operating agreement to make it hard for a creditor to get any traction other than a charging order when they are coming after the LLC.
Your operating agreement should define these relationships. Use my Free LLC Operating Agreement as a second opinion for the operating agreement you’ve got. If you are serious about the protection your LLC gives you, spend the extra couple of dollars and get the two hour audio tutorial I have prepared to go along with the advanced version of the free operating agreement. It will help you with the multi member LLC concepts.
I am amazed at the number of people who tie their whole life up working to make their LLC work and have no clue what charging order protection is and could care less whether they even have an LLC operating agreement. That makes life easy for me as an attorney. No operating agreement – no asset protection.
You’ve got to understand the corporate shield, charging order protection and all the “corporate formalities” that a corporation and an LLC needs to follow. Yes, your multi member LLC has to follow the formalities too, or you don’t get the advertised asset protection. That makes life easy for me and the other attorneys if you screw up. Take a minute to look at your documents and make sure you’re getting the protection you expect.