April 07, 2014

What a single-member LLC can and can’t do to protect your rental property or business

by stownsend

It's become very common for entrepreneurs, landlords, and others to use single member LLCs in their business planning. The single-member LLC offers some advantages of a sole proprietorship, including flexibility and a single level of income taxation. Unlike a sole proprietorship, it keeps the business in a neater "package" that can be easier to sell in a liquidity event, and may also provide a degree of creditor protection.

The creditor protection offered by a single member LLC is helpful, but sometimes it only goes so far, as shown by Olmstead v. Federal Trade Commission, 2010 WL 2518106 (Fla. 2010), which was really nicely discussed a while ago by Juan Antunez. Olmstead suggests that single-member LLCs are not shielded from "reverse piercing" for debts of their sole member.

The facts in Olmstead were pretty extreme: two persons, each a member of their own single-member LLCs, were sued by the FTC for running a credit card scam. The defendants' assets were frozen and placed in receivership. The FTC ultimately received injunctive relief and more than $10 million in restitution.

In Olmstead, the Florida Supreme Court had to reconcile two statutes, one providing a charging order remedy for creditors of LLC members[1], and the other providing a levy and sale under execution remedy for creditors of debtors owning stock in corporations[2].

The charging order remedy provides that on application by any judgment creditor of a member of an LLC, the court may charge the LLC interest of the member/debtor with payment of the unsatisfied amount of the judgment with interest.[3] The judgment creditor will have only the rights of an assignee in the interest that has been charged.[4] This is a right to the debtor/member's interest in the LLC's cash flow, but it is not a right to participate in the governance of the LLC.

Unless the LLC's articles of organization or operating agreement provide otherwise, as an assignee of the LLC interest, the judgment creditor may become a member of the LLC only if all the members other than the debtor/member (deemed to be assigning the LLC interest) consent.[5]

The Olmstead court reconciled the statues from the starting point that the sole member in a single-member LLC may freely transfer the owner's entire interest in the LLC, and the general rule that the debtor's legal or equitable interest in any property the debtor may alienate or assign is subject to payment of the debtor's debts.[6]

The court determined the limitation on LLC assignee rights had no application to the transfer of rights in a single-member LLC, because in a single-member LLC, there are no members other than the member assigning the interest. The court's interpretation was that an assignee of the membership interest of the sole member in a single-member LLC becomes a member â and takes the full right, title, and interest of the transferor â without the consent of anyone other than the transferor.

The Olmstead court acknowledged that a judgment creditor cannot defeat the rights of nondebtor members of an LLC to withhold consent to the transfer of management rights in the LLC, but it did not believe a judgment creditor of an LLC's single member should have less extensive rights than the rights that are freely assignable by the judgment debtor/member.

What does Olmstead show, and what are its implications for business planning?

The case underscores that LLCs can be good "liability insulation" for their single member against issues arising from the assets inside the LLC, or the business operations of the LLC (if the single member respects the LLC as a separate business entity).

Olmstead shows, however, that a single member LLC is not necessarily effective liability insulation for the assets inside the LLC against the debts of the LLC's single member.

You could summarize this distinction by saying that a single member LLC can add asset protection for risks and liabilities flowing "upstream" to the LLC's member, but not necessarily risks and liabilities that flow "downstream" from the owner to the LLC.

A practical application of this insight is for owners of investment real estate. Olmstead shows how it's important to protect each investment property inside a limited liability entity (such as a separate LLC) and with appropriate insurance. That way, if liabilities arising from one property move "upstream" to the investor, and give rise to a judgment creditor of the investor, the creditor can't use the Olmstead rule to reach "downstream" to the value inside the investor's other single-member LLCs.

To obtain maximum protection in light of the Olmstead rule, real estate investors or other entrepreneurs using LLCs to hold a property or business venture should consider using multiple-member LLCs where possible.

Image above credit Sharee Basinger, publicdomainpictures.net.

[1] F.S. 608.433(4).

[2] F.S. 56.061.

[3] F.S. 633.408(4).

[4] Id.

[5] F.S. 633.408(1).

[6] F.S. 56.061.