If you are a member of a limited liability corporation and run into trouble with your personal debts, bankruptcy is still an option for you, even if you are the LLC's only member. However, business owners must make careful decisions when considering whether to file for personal bankruptcy, as this process could affect the business, even if the business itself is not bankrupt.
If you decide to file for personal bankruptcy, your involvement within an LLC will be interpreted by bankruptcy courts as an asset within your estate. With that in mind, the trustee in charge of your bankruptcy may opt to sell your LLC ownership to help settle your debts.
How Limited Liability Companies Work
A limited liability company is a type of business entity, like a corporation, that operates separately and distinctly from the individuals or entities who own it. The owners of an LLC are called members (unlike the owners of a corporation, who are called shareholders or stockholders). An LLC is called "limited liability" because the individual members of the LLC cannot generally be held liable for the actions of the LLC.
When an LLC makes money, the money simply passes through the LLC and goes directly to the members, who use it to pay business expenses and then keep the rest as their compensation. For that reason, LLCs are often called pass-through entities. The members must report all the income of the LLC in their personal tax returns and take deductions for the expenses. Despite this, an LLC is its own entity and is not interchangeable with its members.
Because the LLC is a separate and distinct corporate form, any ownership interest you have in the LLC is considered a property right, just like your ownership interest in your car or your house. In that way, bankruptcy can affect the business.
Filing Personal Bankruptcy
Individuals can file bankruptcy under either Chapter 7, Chapter 11 or Chapter 13 of the federal bankruptcy code, although Chapters 7 and 13 are the most common for individuals. A Chapter 7 case is a liquidation, in which a Chapter 7 trustee is appointed to oversee the case and sell any non-exempt assets of the bankruptcy debtor (the person filing the case). A Chapter 13 is a reorganization for individuals who make enough money to repay some or all of their debts, and the job of the Chapter 13 trustee is to collect that money and pay creditors.
When you file a personal bankruptcy case, you must prepare a list of everything you own. At the moment the case is filed, your assets become property of your bankruptcy estate. This list of assets must be filed whether you're in a Chapter 7 or a Chapter 13 bankruptcy – either filing creates a bankruptcy estate. That list of your property must include your ownership interests in a business. If you are a member of an LLC, you must list your ownership in that LLC as an asset.
LLC Owners in Chapter 7
If you own an LLC and you file Chapter 7, the Chapter 7 trustee may ask for documentation and testimony from you to determine whether the LLC has any value – either in its assets or in its intangibles, such as goodwill, receivables or intellectual property. In the majority of cases, if the owner is filing personal Chapter 7, the LLC is not worth very much. This is especially true if there is more than one member in the LLC, and none of the rest have filed the case – the estate's interest in the LLC is limited by the interest of the person who filed. For example, if you are a member of an LLC with three other people and your ownership interests are equal, you only own 25 percent of the LLC, which is likely not worth much. The trustee can only sell your 25-percent interest in the LLC, or he can try to force the sale of the whole business but will have to pay the other members for their interests.
If the trustee determines that there is value in the LLC, he may decide to sell your interest. Sometimes he may offer to sell it to the other members, or he may find a buyer on his own. He can even offer to sell it back to you, as he is allowed to make compromises on behalf of the estate. In the interim, however, he may decide to step in and operate the business on your behalf while he looks for a buyer so that he can preserve the LLC's assets. He is permitted by federal bankruptcy law to conduct the business of the debtor to preserve the estate.
LLC Owners in Chapter 13
If you own an LLC and file Chapter 13, you will essentially be treated as any other Chapter 13 debtor. You will need to report your income and expenses, including the income you make from operating the business. Based upon various calculations, you will propose a repayment plan that the court must approve. A Chapter 13 trustee has much different duties than a Chapter 7 trustee, and she will not take steps to operate your business or sell any of your assets. Depending on where you live and where you file your case, your local Chapter 13 trustee may have special forms to fill out for business owners.
- U.S. Courts: Chapter 13 - Bankruptcy Basics
- Small Business Administration: 6 Things You Need to Know About Your Tax Responsibilities as an LLC
- U.S. Department of Justice: Handbook for Chapter 13 Standing Trustees
- U.S. Courts: Chapter 7 - Bankruptcy Basics
- U.S. Department of Justice: Handbook for Chapter 7 Trustees
Rebecca K. McDowell is an attorney focused on debts and finance. She has a B.A. in English and a J.D. She has written finance and tax articles for Zacks and eHow.