When creditors come for assets in an LLC formed in another state, which state laws apply?

Question

I am heavily indebted.I also want to start a business. I want to protect my assets from creditors. If I put my personal assets into my business, will they be protected? From what I understand, Wyoming and some other states are business friendly in their incorporation laws. But if I am doing business in another state and residing in another state, will the credit dispute be covered under the laws of the state of incorporation, or my state of residency, because that changes things significantly. For example, that may mean that I would be better off forming the LLC in my resident state rather than in another state if the other state's laws do not apply in a special case.

Answer 1

It sounds like what you are discussing is a personal liability unrelated to the business which you want to protect from your personal creditors by contributing to an LLC.

This is not the usual way that an LLC is used to limit liability. Normally, the idea is that you put business assets into the LLC and that creditors of the LLC arising out of contracts that the LLC enters into and out of legal wrongs committed by the LLC in which you did not have personal involvement (which would give rise to personal liability on your part) are limited to collecting from the assets that have been put in the LLC, thereby protecting your personal assets.

The reverse is not true. As a general rule, ownership interests in an entity are not exempt from the claims of a general creditor of the owner of the entity. What practical rights this gives a creditor, however, in the case of a closely held unincorporated entity (like an LLC with a small number of members) is a bit involved.

So, while sometimes, the ownership of an asset in the LLC form may provide, as an accidental consequence of the procedures involved in enforcing a judgment, some degree of asset protection, this has no policy justifications or intentional legislative intent to provide asset protection to support it, so courts feel more free to find artificial solutions to the artificial problems created by this kind of tactic.

So, suppose that you do have personal assets that you do put into an LLC and a personal creditor tries to satisfy a judgment out of those assets.

There are basically six avenues available to your personal creditor (you can quibble with my lumping and grouping of remedies to get a different number and I'm sure there are one or two I have omitted):

1. Impose a "charging order" upon the LLC or garnish amounts that the LLC owes to you. (A 'charging order" includes future amounts that will come due, a garnishment pertains to amounts that are currently enforceable debts that you are owed from the LLC.) Basically this involves tapping your income stream from the LLC much as you might garnish wages. Typically 100% of the amount distributed from the LLC would be subject to diversion to the creditor. This remedy is almost always available to a creditor of an LLC owner.

2. Execute upon and seize your membership interest in the LLC much as you would on shares of stock in a large publicly held company. The creditor gets your ownership interest in the LLC as property for payment of the debt, and that LLC interest then, in turn, can be used potentially to either access the assets that the LLC owns or to force the dissolution of the LLC and related distribution of its assets to the owners (one of whom would be your personal creditor). Often the law regarding the availability of this remedy is undeveloped and unclear. The Court could also order you to turn over your membership interest in the LLC to the creditor, or to exercise your voting rights in the membership interest to take particular actions that you have a right to take.

3. Attack the transfer of personal assets to the LLC as a fraudulent transfer made with an intent to conceal assets from present or future creditors, or to hinder collection of present or future debts. This remedy is almost always available. This remedy is also particularly likely to be utilized if the debt was in existence at the time of the transfer, if the assets transferred do not generate income, and if the assets transferred are used for personal benefit by the person transferring them to the LLC.

4. Attack the LLC's very existence as an alter ego of you that should be ignored entirely. I am aware of bankruptcy court cases that do this in the case of single member LLCs. This is harder to argue in the case of multiple member LLCs where the other owners are distinct from you and not obligated on your personal debt. This is sometimes called "reverse veil piercing" and is expressly authorized by case law in most states that have considered the issue at all.

5. The court in which the judgment was entered could issue an order directing you, if you controlled the entity, to turn over the asset owned by the LLC to the creditor as an equitable remedy and injunction punishable by contempt of court if not honored (this is particularly common in child support and alimony judgment cases). This is generally not possible, however, in the case of an LLC in which you do not have a controlling interest and are instead a minority interest owner.

6. The creditor could force you into an involuntary bankruptcy in which your membership interest in the LLC is distributed to creditors as an asset of the bankruptcy estate, in which case federal bankruptcy law would govern.

All of these remedies would ordinarily be pursued in the court where the money judgment against you was obtained by your personal creditor. This would as a default apply the law of the jurisdiction where the court is located.

But, it is plausible and maybe even likely that the court where the judgment was entered would consider the law of the state of formation of the LLC with respect to the first two remedies (LLC's are "formed" or "organized" in a jurisdiction, never "incorporated").

My language regarding choice of law is equivocal because modern choice of law rules are very vague and wishy washy and subject to manipulation. In the 19th century and early 20th century, choice of law rules were typically clear, bright line rules that left no doubt regarding which jurisdiction's law applied to a dispute. But, in the late 20th century, the law evolved and is now extremely vague in most cases, for example, stating that "the law with the most significant relationship" to a legal issue should be applied.