Limited Liability Companies

Proposed Changes to Indiana LLC Statute Part 2: Charging Order Protection

February 8, 2013 | Michael R. Smith

UPDATE, February 19, 2013.
Yesterday, the House Judiciary Committee amended HB1394 to remove the language discussed in this blog post — the changes to IC 23-18-6-7 that would have expressly provided that a charging order is the only right that the creditor of an LLC member has with respect to the LLC. It appears that Indiana will remain in the fourth category of states listed in the article — those in which there is no reverse veil piercing for multi-member LLCs, with the issue remaining unsettled with respect to single member LLCs. The most recent version of the bill is available here.

In my last post, I discussed HB 1394, a bill pending in the Indiana General Assembly that would make several amendments to the statute that governs Indiana limited liability companies. One of the most important changes is to strengthen the so-called “charging order” protection, which I’ll describe shortly after a brief review of some attributes of LLCs and corporations.

Recall that corporations and LLCs both have liability shields that protect the owners of the company (for a corporation, the shareholders; for a limited liability company, the members) from being personally liable for the company’s obligations. That liability shield (whether it’s for a corporation or LLC) is sometimes called a corporate veil, and in some circumstances courts will ignore the shield, or pierce the corporate veil, to allow creditors of the business to reach the personal assets of the owners. I’ve previously discussed precautions that LLC members can take to keep that from happening.

When a court allows a creditor of the business to reach the personal assets of the owners, it’s sometimes called “inside-out veil piercing,” which implies there might be something else called “outside-in veil piercing.” And there is.

Consider what happens when a shareholder of a corporation owes money to a creditor. The shareholder’s stock is just like any other asset, like a bank account, a house, or a car. And just like any other asset (well, most other assets), the stock is subject to foreclosure, which effectively means the creditor takes over ownership. The creditor, now the new shareholder, receives all the rights associated with the stock, including the economic rights (i.e., the right to receive dividends, if there are any) and the non-economic rights (including the right to vote in elections of the board of directors). That’s called “outside-in veil piercing” or sometimes “reverse veil piercing.” If the creditor takes over enough shares of stock, he or she can gain control of the company. Even if the creditor does not gain control of the company, the other shareholders may suddenly find themselves co-owners with someone they don’t even know, maybe even with someone they despise. For large, publicly traded companies with millions of shareholders, that’s no big deal. For family businesses or other businesses with only a few shareholders, it can be a very big deal.

The area of reverse veil piercing is one in which LLCs differ tremendously from corporations, at least in some states, and it is one of the reasons that I advise clients to set up LLC’s far more often than I advise them to set up corporations. When it comes to the rights of a member’s creditors, many states, including Indiana, treat the member’s economic rights and non-economic rights separately. For example, IC 23-18-6-7 allows a court to issue an order requiring a limited liability company to pay to a member’s creditors anything that the LLC would otherwise be required to pay to the member. That’s called a charging order, and it’s something like an order for the garnishment of wages, applied to a member’s right to receive LLC distributions.

The question is whether a charging order is the only remedy a creditor has against the member’s rights. If so, there is no reverse veil piercing, and a member’s creditors cannot take over control of the business or gain a seat at the table with the other members. I believe there are currently five categories of states:

Those in which reverse veil piercing is not allowed for LLCs.
Those in which reverse veil piercing is allowed for single-member LLCs but not for multi-member LLCs.
Those in which reverse veil piercing is allowed for both single-member LLCs and multi-member LLCs (essentially treating LLCs the same as corporations).
Those in which there is no reverse veil piercing for multi-member LLCs but for which the law is unresolved for single-member LLCs.
Those in which the law is unresolved for reverse veil piercing both single-member and multi-member LLCs.

Until fairly recently, Indiana was in the fourth group of states. As I’ve discussed elsewhere, a 2005 decision of the Indiana Court of Appeals, Brant v. Krilich, held that there is no reverse veil-piercing for multi-member LLCs, but apparently leaving the question open for single-member LLCs.

HB 1394 would add a provision to IC 23-18-6-7 expressly stating that a charging order is the exclusive remedy for a judgment creditor of a member and that the creditor has no right to foreclose on the member’s interest. Because the bill makes no distinction between single-member and multi-member LLCs, it appears that HB 1394 would place Indiana in the first category of states — those for which reverse veil piercing is not allowed for either single-member or multi-member LLCs.
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Proposed Changes to Indiana LLC Statute

January 29, 2013 | Michael R. Smith

Statutes governing limited liability companies, or LLCs, vary considerably from state to state. In our opinion, Indiana’s statute is already among the best in the country, and a bill introduced in the 2013 session of the Indiana General Assembly proposes several changes that would make it even better for small business owners, particularly family-owned businesses. Among other things, HB 1394, introduced by Rep. Greg Steuerwald (R Avon) would:

Eliminate the possibility that a creditor of a member can take over the member’s voting rights
Allow a membership interest to be held in joint tenancy with the right of survivorship
Allow a membership interest to be designated as “transfer on death” property
Expressly provide for LLC officers

Later posts will discuss these proposed changes in more detail, including a few suggestions for possible revisions to the bill that would make it even better. In the meantime, however, small business owners in Indiana may want to contact their state representatives and senators urging them to support HB 1394.
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Just what IS a limited liability company? Part 7. It’s a bundle of tax choices.

March 7, 2011 | Michael R. Smith

[This is the last of a seven-part series of posts discussing the characteristics of limited liability companies and comparing them to the characteristics of corporations, general partnerships, and sole proprietorships. Here’s the entire list.

Part 1. Background on sole proprietorships.
Part 2. Background on partnerships.
Part 3. Background on corporations.
Part 4. LLCs are distinct legal entities, separate from their owners.
Part 5. A limited liability company’s owners are not liable for the LLC’s obligations.
Part 6. Options for an LLC’s management structure.
Part 7. Options for an LLC’s tax treatment.]

In prior posts, I’ve discussed several characteristics of LLCs. First, like corporations, LLCs are entities separate from their owners. Second, also like corporations, the owners are not liable for the obliigations of the LLC. Third, they offer choices of management structures: They can be managed directly by the owners, like sole proprietorships and many partnerships, or they can be managed by others who are selected by the owners, in much the same way that shareholders of a corporation elect directors to run the business. This last post of the series looks at the tax characteristics of LLCs.

Interestingly, LLCs do not have a specific category in the Internal Revenue Code or the Tax Regulations. Instead, their tax treatment is governed by the so-called “check-the-box regulation.” It provides that the LLC may elect to be treated in one of several ways, and the choices depend on whether the LLC has one member or more than one member.

The default status for a single-member LLC is that it is a “disregarded entity” in that all the income and expenses go directly on the member’s personal tax return, just like a sole proprietorship. The LLC itself doesn’t even have to file a tax return. The default status for a multi-member LLC is to be taxed as if it were a partnership. Alternatively, either a single-member LLC or a multi-member LLC can elect to be taxed as if it were a corporation, either as a Subchapter C corporation or, if the LLC meets certain criteria, as a Subchapter S corporation. To decide which is the best tax strategy for your LLC, you should consult both your lawyer and your accountant.
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Just what IS a limited liability company? Part 6. It offers choices of management structure.

February 20, 2011 | Michael R. Smith

[This is the sixth post in a seven-part series discussing the characteristics of limited liability companies and comparing them to the characteristics of corporations, general partnerships, and sole proprietorships. Here’s the entire list.

Part 1. Background on sole proprietorships.
Part 2. Background on partnerships.
Part 3. Background on corporations.
Part 4. LLCs are distinct legal entities, separate from their owners.
Part 5. A limited liability company’s owners are not liable for the LLC’s obligations.
Part 6. Options for an LLC’s management structure.
Part 7. Options for an LLC’s tax treatment.]

Previous posts discussed the management structures of the three classic business entities that we’re using as a framework for discussing limited liability companies and, in particular, exactly who is responsible for running the business day-to-day.

Sole Proprietorships. Remember Drucker’s General Store, the example I used to illustrate sole proprietorships? Sam Drucker ran his own store on a day-to-day basis. In fact, I’m not sure Sam even had any employees. That’s the prototypical management structure for a sole proprietorship — the proprietor himself or herself runs the business on a day-to-day basis.

Corporations. Once again, corporations are at the opposite end of the spectrum from sole proprietorships. As discussed earlier,the owners of a corporation (i.e., the shareholders), have no role in the day-to-day operation of the business. Instead, their role is limited to electing a board of directors who, in turn, usually delegate responsibility to officers and employees of the company. Of course, in a closely held company, it’s very common for the owners, acting as shareholders, to elect themselves as directors and then to appoint themselves as officers.

General Partnerships. The management structure of general partnerships varies a bit more, but usually the day to day affairs are managed by the partners themselves — by all of the partners, or by a management committee composed of partners, or by a single managing partner.

Limited Liability Companies. Fundamentally, there are two different ways limited liability companies can be managed — by the members themselves or by one or more managers, who are appointed by the members. In other words, a limited liability company has the flexibility to be managed like a sole proprietorship and many partnerships are managed — by the owners of the business themselves. However, it’s also possible for the owners to be relatively far removed from the day-to-day operation of the company, with a role largely restricted to appointing one or more managers to operate the LLC. Note, however, that the members of a manager-managed LLC are free to name one or more of their own as manager(s).

Even a single-member LLC has the same choices of management by the members or management by managers. A few days ago, in explaining why a single-member LLC needs an operating agreement, I touched on some of the reasons that the sole owner of a limited liability company might choose to make their LLC manager-managed.

So one of the advantages of a limited liability company is that it offers choices for management structure. Next we’ll see that a limited liability company offers choices for tax treatment as well.
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Why should a single-member LLC have an operating agreement?

February 18, 2011 | Michael R. Smith

Under current Indiana law, you can easily start up a limited liability company (LLC) with a credit card and an internet connection. After making a quick trip to the Indiana Secretary of State’s website, submitting articles of organization, and paying a fee you could have your very own LLC in about fifteen minutes. But what about creating an operating agreement for your LLC? Nothing about that process requires — or even mentions — an operating agreement. Strictly speaking, it’s not legally required, and if the LLC has only one member, an operating agreement may even seem pointless. Nonetheless, I advise all my clients with LLCs — even single-member LLCs — to have operating agreements.

The reason the Indiana Business Flexibility Act does not require an operating agreement is that it contains default rules that govern the LLC if there is no operating agreement (or if there is an operating agreement but it doesn’t address every issue). However, those default rules may or may not be what you want. Having an operating agreement created specifically for the needs and goals of your single-member LLC can help sort out which aspects of the Indiana Business Flexibility Act will apply to your LLC and which will be overridden.

A particular reason that I think single-member LLCs should have an operating agreement flows from the fact that I think most single-member LLCs (at least those owned by individuals rather than by another business entity) should be manager-managed rather than member-managed. Imagine you are the sole member of your own LLC, and it is member-managed. That means that you, and only you, have the authority to take actions on behalf of the LLC. Now imagine that you are in a serious accident and unable to manage your business for an extended period of time. There is no one who can step into your shoes and run the business in your absence.

However, imagine that you set the business up as a manager-managed LLC. You can name yourself as the manager and some other trusted person, such as your spouse, as the assistant manager who has the authority to step in and run the LLC if you are not able to. To do that, you’ll need an operating agreement that describes the authority of the other person to run the business when you can’t.

It’s also likely that third parties, such as banks and the IRS, will want to know various details about how the LLC is organized. An operating agreement includes information like who has the authority to sign contracts for the LLC, the LLC’s tax status, and other legally meaningful information. Being able to hand a third party a single document that clearly lays out all of the legally significant details about the LLC can save a lot of time and confusion for the member and the entities the LLC does business with.
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Just what IS a limited liability company? Part 5. It has a liability shield.

February 17, 2011 | Michael R. Smith

[This is the fifth post in a seven-part series discussing the characteristics of limited liability companies and comparing them to the characteristics of corporations, general partnerships, and sole proprietorships. Here’s the entire list.

Part 1. Background on sole proprietorships.
Part 2. Background on partnerships.
Part 3. Background on corporations.
Part 4. LLCs are distinct legal entities, separate from their owners.
Part 5. A limited liability company’s owners are not liable for the LLC’s obligations.
Part 6. Options for an LLC’s management structure.
Part 7. Options for an LLC’s tax treatment.]

The last entry in this series explained that a limited liability company has its own legal identity, separate from its members. A related concept is that a limited liability company has a liability shield, sometimes called a corporate veil, between itself and its members. That means that the members of a limited liability company are not liable for the debts or obligations of the LLC itself, just as the shareholders of a corporation are not liable for the debts or obligations of the corporation itself.

To see how that works, let’s imagine that you and two of your good friends, Jack and Jill, decide to buy a bicycle shop. You consult an attorney, and he recommends that you create a limited liability company to buy the shop. He writes an operating agreement for you, which all three of you sign, files articles of organization in the Indiana Secretary of State‘s office, and takes care of other details such as obtaining an Employer Identification Number . At that point you are the proud owners of a limited liability company Three Good Friends, LLC . (By the way, there is no such LLC in Indiana. I know that because I ran a search on the Secretary of State’s website.) The purpose of the LLC is to buy and run a bicycle shop. To raise the money, you and Jill each drain your savings accounts, and Jack mortgages his house to the hilt. All three of you put the money (called your initial capital contributions) into the LLC, and with that money the LLC buys a bicycle shop, which you rename as Three Good Friends Bicycle Emporium. The LLC’s lawyer files a certificate of assumed business name showing that Three Good Friends, LLC is now doing business as Three Good Friends Bicycle Emporium.

While you’re working in the shop one afternoon, a delivery truck arrives. A LARGE delivery truck. The driver comes in and asks where you’d like to put the 700 bicycles you ordered. (I don’t know if a single truck can actually hold 700 bicycles, but cut me some slack and go with me on this.) You tell him there must be some mistake because you ordered only 7 bicycles. After a frantic search through your computer files, you realize that a mistake was indeed made — and that you’re the one who made it. You really did order 700 bicycles. And they’re expensive bicycles. VERY expensive. You make a few phone calls and find out that the bicycles cannot be returned and that the shop will have to pay for them. You also know that there’s not nearly enough money in the LLC’s bank account to pay for the bicycles.

You tell Jack and Jill what happened, expecting them to be furious — and Jack is. As Jack often does, he imagines the worst. He says that the bicycle manufacturer is going to sue not only the shop but all three of you. He worries that not only will the three of you lose the business, but that he’ll lose his house, which he mortgaged to the hilt to come up with the money for the business. Jill, being her characteristically calm self, tells Jack not to worry. The reason that they set up a limited liability company was so that none of the three good friends can be held liable for the debts of Three Good Friends Bicycle Emporium. She tells Jack that even if the LLC goes bankrupt, his house is safe from the bicycle manufacturer. Is Jill right?
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Just what IS a limited liability company? Part 4. It’s a separate legal entity.

February 17, 2011 | Michael R. Smith

[This is the fourth post in a seven-part series discussing the characteristics of limited liability companies and comparing them to the characteristics of corporations, general partnerships, and sole proprietorships. Here’s the entire list.

Part 1. Background on sole proprietorships.
Part 2. Background on partnerships.
Part 3. Background on corporations.
Part 4. LLCs are distinct legal entities, separate from their owners.
Part 5. A limited liability company’s owners are not liable for the LLC’s obligations.
Part 6. Options for an LLC’s management structure.
Part 7. Options for an LLC’s tax treatment.]

To set the background for a discussion of the basics of limited liability companies, we’ve discussed sole proprietorships, partnerships, and corporations. As we’ll see, a limited liability company shares some characteristics with corporations and other characteristics with sole proprietorships (if the LLC has one owner, called a member) or partnerships (if the LLC has more than one member).

The first thing to recognize about a limited liability company is that it is a separate legal entity, apart from its owners. How does that compare to the other structures? First, a sole proprietorship is NOT a separate legal entity apart from its owner. If you’re running a business as a sole proprietorship, you really ARE the business, and the business is you.

At the other end of the spectrum, a corporation is a distinct legal entity, completely separate from its shareholders. For example a corporation can sue and be sued in its own name, It can enter into contracts in its own name. And it can go into bankruptcy without dragging its owners with it.

In the middle of the spectrum is a partnership. Without getting into all the details, I’ll just say that for some purposes a partnership has the characteristics of a separate legal entity, and for other purposes a partnership is treated more like the aggregate of all the partners.

So in this sense, a limited liability company is just like a corporation. It is a separate legal entity, apart from its members. It can sue and be sued; it can enter into contracts; and it can go into bankruptcy, all apart from its members. And all that is true even if the LLC has only a single member.

Next we’ll discuss another way that a limited liability company is like a corporation — the liability shield.
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Just what IS a limited liability company? Part 3. It’s not a corporation.

January 30, 2011 | Michael R. Smith

[This is the third post in a seven-part series discussing the characteristics of limited liability companies and comparing them to the characteristics of corporations, general partnerships, and sole proprietorships. Here’s the entire list.

Part 1. Background on sole proprietorships.
Part 2. Background on partnerships.
Part 3. Background on corporations.
Part 4. LLCs are distinct legal entities, separate from their owners.
Part 5. A limited liability company’s owners are not liable for the LLC’s obligations.
Part 6. Options for an LLC’s management structure.
Part 7. Options for an LLC’s tax treatment.]

Let’s get back to our trek toward a discussion of the basics of limited liability companies. The first two types of business structures we’ve looked at — sole proprietorships and partnerships — have two significant features in common. First, the owner or owners are liable for the obligations of the business. Second, the business itself does not pay taxes. Instead, the income and other tax items are “passed through” to the owner or owners, who pay tax on the income. Things change with corporations, the third type of business structure.

Although corporations are not as old as sole proprietorships or partnerships, business organizations with at least some of the characteristics of corporations have been around for centuries. For example, the oldest corporation in North America, Hudson’s Bay Company, was incorporated in 1670.

Perhaps the most important feature of a corporation is that the owners of the corporation — called stockholders or shareholders — are NOT liable for the obligations of the business. And that’s very good news for people who owned stock in Lehman Brothers, which melted down into the largest bankruptcy in American history. Or, going back a little further to previous record holders, people who owned stock in Enron and Worldcom. Even though the people who owned stock in those corporations may have lost everything they invested, they were not liable to the corporations’ creditors, and they did not get pulled into the corporate bankruptcies. That protection against shareholders being held liable for the corporation’s obligations is sometimes called a liability shield or a corporate veil, and it doesn’t exist for sole proprietorships or general partnerships.
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Just what IS a limited liability company? Part 2. It’s not a partnership.

January 23, 2011 | Michael R. Smith

[This is the second post in a seven-part series discussing the characteristics of limited liability companies and comparing them to the characteristics of corporations, general partnerships, and sole proprietorships. Here’s the entire list.

Part 1. Background on sole proprietorships.
Part 2. Background on partnerships.
Part 3. Background on corporations.
Part 4. LLCs are distinct legal entities, separate from their owners.
Part 5. A limited liability company’s owners are not liable for the LLC’s obligations.
Part 6. Options for an LLC’s management structure.
Part 7. Options for an LLC’s tax treatment.]

In the last entry, I began a discussion of the basics of limited liability companies. To start that discussion, I began by describing the first of three other types of business structures: sole proprietorships. This entry is about partnerships, and the next will describe corporations.

In a sense, a general partnership is like a sole proprietorship, but with multiple proprietors. Each partner is liable for all of the obligations of the partnership. In other words, a creditor of the partnership can sue any or all of the partners to collect what the partnership owes. Income taxes are also similar, but things get a little more complicated with multiple owners.

For tax purposes, a general partnership is a “pass-through entity.” Unlike a sole proprietorship, a partnership has to file a tax return, called Form 1065. However, the partnership itself does not have to pay taxes. Form 1065 is used to calculate the partnership’s profits or losses and other “tax items,” which are allocated to the partners, most often in proportion to their ownership interests. In other words, the tax items are “passed through” to the partners, and each partner receives a report from the partnership called a Schedule K-1 that tells the partner how much income, etc. to report on his or her own personal tax return. Then the partner pays income tax as an individual.

One more point worth noting about taxes. If the partner is actively involved in the operation of the partnership — in essence, if the partner is “employed” by the partnership — he or she is considered to be self-employed and must pay self-employment tax on his or her share of the partnership’s income. Again, being a partner is very much like being a sole proprietor, except for the “sole” part.

The general partnership is an old form of business association. For instance, in Dickens‘s A Christmas Carol, Ebenezer Scrooge and Jacob Marley were partners. “The firm was known as Scrooge and Marley. Sometimes people new to the business called Scrooge Scrooge, and sometimes Marley, but he answered to both names. It was all the same to him.” Id. at p. 3. Of course, I’m not holding out Scrooge and Marley as a typical partnership or as a model of customer service. The example came to mind only because last month our family attended the Indiana Repertory Theater‘s annual production of A Christmas Carol, and I’ve always liked that line.

In the next entry, I’ll describe corporations, and then (finally!) get around to discussing limited liability companies.
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Just what IS a limited liability company? Part 1. It’s not a sole proprietorship.

January 22, 2011 | Michael R. Smith

[This begins a seven-part series of posts discussing the characteristics of limited liability companies and comparing them to the characteristics of corporations, general partnerships, and sole proprietorships. Here’s the entire list.

Part 1. Background on sole proprietorships.
Part 2. Background on partnerships.
Part 3. Background on corporations.
Part 4. LLCs are distinct legal entities, separate from their owners.
Part 5. A limited liability company’s owners are not liable for the LLC’s obligations.
Part 6. Options for an LLC’s management structure.
Part 7. Options for an LLC’s tax treatment.]

Limited liability companies or LLCs, particularly Indiana limited liability companies, will be a frequent topic of posts on this blog. To set the stage, I’d like to start with the most basic question: Exactly what IS a limited liability company? It will take me a few posts to go over the basics, but then I’ll move on to more sophisticated topics.

Way back, a long time ago, when I was in school (probably high school, but I’m not sure), I was taught that there are three types of business structures: sole proprietorships, partnerships, and corporations. Even then, that was a bit simplistic because there were other types of businesses, but that covered most of the waterfront. Today, it doesn’t come close because the most popular form for new small businesses is a limited liability company. However, the easiest way to understand what a limited liability company IS is to understand first what it is NOT. So let’s start with sole proprietorships.

As I learned way back then, a sole proprietorship is the classic one-person business in which the owner and the business are one and the same, even if the business is operated under some other name. I always thought of Drucker’s General Store on the television shows Petticoat Junction and Green Acres. (I told you it was a long time ago!) Most likely, Drucker’s General Store was a sole proprietorship. Sam Drucker and his store were one and the same. In other words, anything the store owned, Sam owned. On the flip side, anything the the store OWED, Sam owed.

For example, if someone slipped and fell on a pickle from Sam’s pickle barrel (I don’t remember if Sam had a pickle barrel, but he MUST have had one!) and successfully sued the store, the plaintiff could take money not only from the store’s cash register and bank account, but also from Sam’s bank account – and maybe even his house. That’s a disadvantage of a sole proprietorship. An advantage is that (unlike corporations, as well discuss later), the business itself does not have to pay income taxes. The income from the business goes straight to the owners Form 1040, on Schedule C to be specific, and the owner pays the taxes.

So a limited liability company is not a sole proprietorship. Next we’ll discuss partnerships, another type of business structure that differs from an LLC.
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