About Limited Liability Corporation Bankruptcy Laws
Bankruptcy petitioners, lawyers and judges navigate uncharted legal waters in cases involving limited liability corporations (LLCs). States began chartering LLCs fairly recently. As of yet, the U.S. Bankruptcy Code makes no mention of them. Case law legal precedents so far offer only partial answers to a very basic question: Should a bankruptcy judge treat an LLC as a full-fledged corporation, a limited partnership or a sole proprietorship? A lot rides on the answer.
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Types
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Legally incorporated companies enjoy limited liability. Shareholders' personal assets cannot be seized in a Chapter 7 liquidation. A distressed corporation can file under Chapter 11, reorganize itself and remain in business. The court dissolves a bankrupt limited partnership but requires members only pay creditors the amount they have invested in the partnership. Unincorporated, insolvent sole proprietors have their personal assets seized or file under Chapter 13 and make monthly payments to creditors for three or five years.
Considerations
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Forty-seven states now legally recognize but do not incorporate LLCs. States issue Articles of Organization instead. Some lawyers argue they so closely resemble articles of incorporation that limited liability applies to LLCs. Other lawyers claim LLCs function more like limited partnerships and should be treated accordingly. They point to how the Internal Revenue Service assesses the same tax rate on multiple-member LLCs as it does on limited partnerships. But single-member LLCs pay the same rate as sole proprietorships even though many bankruptcy judges consider them a form of limited partnership.
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Effects
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Bankruptcy judges wrangle with the hybrid nature of LLCs. Part corporation, part partnership, they skirt traditional legal boundaries. Relevant state statutes and regulation offer some guidance but are far from comprehensive. That gives judges considerable latitude to rule as they see fit. Bankrupt LLCs face a lot more uncertainty than other kinds of businesses. Because the laws are so open-ended, rulings often get appealed. Court cases drag on, legal fees mount, but automatic stays preventing creditors from collecting remain in place.
Warning
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A momentary decision can cost a single-person LLC dearly. Some banks require that LLCs waive their liability to get a loan. Never sign a contract in your own name or pay a vendor with a personal check. In doing so, you act like a sole proprietor. And that gives the court grounds to rule you are not an LLC. Your case gets converted into a personal bankruptcy, and you suddenly stand to lose everything.
Prevention/Solution
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The law evolves slowly, while business by comparison changes at break-neck speed. That sums up the current state of LLC bankruptcy law. Until Congress amends the U.S. Bankruptcy Code and specifically addresses the LLC issue, courts will continue to rule piecemeal on how to dispose of insolvent ones' assets. As appeals wind their way through higher courts, one argument will gain increasing judicial favor. In the interim, Congress may weigh in. In either case, the U.S. Court of Appeals and the Supreme Court will have the final say.
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