What happens to ownership of a limited liability company when a member files for bankruptcy?

When a member of an LLC files bankruptcy, it not only affects that member but it could also affect the remaining members and the LLC itself.

Limited liability companies are governed by the Uniform Limited Liability Company Act, Idaho Code § 30-25-101, et seq. A member’s transferable interest in a limited liability company is personal property. Idaho Code § 30-25-501. The Bankruptcy Code defines “property of the estate” as “all legal or equitable interests of the debtor in property as of the commencement of the case.” 11 U.S.C. § 541(a)(1). Therefore, membership interests in an LLC may be property of the estate in the event an individual member files for bankruptcy. See In re A-Z Electronics, LLC, 350 B.R. 886 (Bkrtcy.D.Idaho 2006).

Since the member’s interest is included in the bankruptcy estate, what rights do the Trustee have in relation to those transferred interests? Idaho Code § 30-25-502 dictates the transfer of transferable interests:

• Subject to section 30-25-503(f), Idaho Code, a transfer, in whole or in part, of a transferable interest:
• Is permissible, except the transfer of a transferable interest in a professional entity is not permissible without compliance with section 30-21-901(i), Idaho Code;
• Does not by itself cause a member’s dissociation or a dissolution and winding up of the limited liability company’s activities and affairs; and
• Subject to section 30-25-504, Idaho Code, does not entitle the transferee to:
• Participate in the management or conduct of the company’s activities and affairs; or
• Except as otherwise provided in subsection (c) of this section, have access to records or other information concerning the company’s activities and affairs.
• A transferee has the right to receive, in accordance with the transfer, distributions to which the transferor would otherwise be entitled.

As it appears in the Idaho Code, it seems easy enough to understand that the transfer of the debtor’s membership is merely economic in nature (membership interest and its value), excluding non-economic rights, i.e. voting rights. Thus, the Trustee may only having rights to receive distributions. However, in In re A-Z Electronics, LLC, the Court held:

What becomes property of the estate when a member of an LLC files bankruptcy depends on the facts. In In re Garrison-Ashburn, L.C., 253 B.R. 700 (Bankr.E.D.Va.2000), the court considered the impact of the bankruptcy filing of a 50% member in an LLC. Id. at 704-708. It observed that such a member-debtor’s ‘economic rights’ (the membership interest and its value) fall squarely within § 541(a)(1), but so, too, do his ‘non-economic rights’ (such as the ability to participate in management) because § 541(a)(1) is so broadly—and intentionally—drafted. Id. at 707-08.

However, In re Albright, 291 B.R. 538 (Bankr.D.Colo.2003), illustrates the difference between a single-member LLC and a multi-member LLC. It found that where ‘there are no other members in the LLC, … the Debtor’s bankruptcy filing effectively assigned her entire membership interest in the LLC to the bankruptcy estate, and the Trustee obtain all her rights, including the right to control the management of the LLC.’ 291 B.R. at 540. The right to control (and not just ‘participate’ in) management is significant. ‘Because the Trustee became the sole member of [the] LLC upon the Debtor’s bankruptcy filing, the Trustee now controls, directly or indirectly, all governance of that entity, including decisions regarding liquidation of the entity’s assets.’ 291 B.R. at 541.

350 B.R. 886 (Bankr. D. Idaho 2006). See Memorandum of Decision Case No. 03-04278-TLM.

Protect your limited liability company. Operating agreements may address these situations, members may meet to discuss these concerns or members may just run the risk of fellow members filing for bankruptcy.

If you are deciding whether to form a limited liability company, think about how a member’s choice in filing for bankruptcy could impact that interest and find ways to protect the other members and their interests. Do what you can to protect your LLC.

Contact an Attorney at Idaho Bankruptcy Center by Calling (208) 392-1551