LLC Protection for Members' Personal Debt in California (2024)

When you personally owe a debt, creditors can take action to collect that debt, including getting a judgment against you. When a creditor gets the court to order you to pay a debt, the creditor becomes a "judgment creditor." Your state's laws will determine how a judgment creditor can go about collecting the judgment. And, if you're an owner of a limited liability company (LLC), you'll want to check your state's laws to see what the judgment creditor can take from your company if anything.

Let's take a look at what California's laws say about what protections you have as a California LLC owner ("member").

General Rule: LLC Isn't Liable for Members' Personal Debts

The general rule in all states, including California, is that creditors can't take the money or property of an LLC to pay off the personal debts or liabilities of the LLC's owners. Like corporations, the money or property held by an LLC belongs to the LLC, not the members individually. As a result, the LLC's property can't be taken by creditors to pay a member's debts.

This protection from personal creditors is one of the key reasons people form LLCs. An LLC provides its members with personal liability protection from the company's business debts. In addition, the LLC protects the business and its owners from exposure to any debts or personal liability the other LLC members might incur that are unrelated to the LLC's business.

General Protections of California LLC Members

When you owe a debt and are an LLC member, you should generally consider three actions the judgment creditor can potentially take against you:

• The judgment creditor gets the LLC to pay your LLC distributions and income to them rather than to you.
• The judgment creditor takes over your financial rights and interest in the LLC.
• The judgment creditor forces the LLC to dissolve and collects the judgment from the LLC's assets.

In California, the judgment creditor can take the first two actions but not the third:

• The judgment creditor can get a court to order the LLC to pay them any LLC distributions and income meant for you (called a "charging order").
• The judgment creditor can foreclose on your financial interest in the LLC, meaning they have full rights in your LLC distributions and in your share of the LLC's assets if the LLC dissolves.
• The judgment creditor, however, can't force your California LLC to dissolve.

Let's look at these options in more detail.

California LLCs and Charging Orders

California allows creditors of LLC members to obtain a charging order to collect on a judgment obtained against an LLC member. A charging order directs the LLC to pay to the creditor any distributions of income or profit that would otherwise be distributed to the indebted LLC member. Creditors with a charging order in California, like in most states, only obtain the LLC member's financial rights and can't participate in the LLC's management. (Cal. Corp. Code § 17705.03 (2024).)

Because a judgment creditor with a charging order can't participate in the LLC's management, they also can't:

• order the LLC to make a distribution, or
• order the LLC be sold to pay off the debt.

Frequently, creditors who obtain charging orders against LLCs end up with nothing because they can't order the LLC to make any distributions and the LLC can choose not to make any.

Although a charging order is often a weak remedy for a creditor, it's not necessarily toothless. The existence of a charging order can make it difficult or impossible for the indebted LLC member or the other members (if any) to take money out of an LLC business without paying the judgment creditor first.

Let's look at an example: Suppose John, Meghan, and Louis form a California LLC to operate their website design business. John, a big spender, owes $38,000 on his personal credit cards. When he doesn't pay, the accounts are turned over to a debt collection agency which obtains a $38,000 court judgment against him. While the collection agency can attempt to collect the debt from John's personal assets, it can't take money or property owned by the LLC. For example, it can't get any of the money held in the LLC's bank account.

However, the collection agency can ask the court to enter a charging order against John's LLC interest. If the agency obtains the charging order, the LLC must pay the collection agency any LLC distributions that would otherwise go to John.

Creditors Can Foreclose on California LLC Members

Unlike other states, California's LLC law doesn't say that a charging order is the exclusive remedy of an LLC member's personal creditors. Rather, under California's Revised Uniform LLC Act, a creditor can foreclose on the indebted member's LLC interest.

Specifically, the creditor must show that the distributions from a charging order won't pay off the debt within a reasonable time. If the creditor can satisfy this standard, then the court will order the indebted member's financial rights in the LLC to be sold. (Cal. Corp. Code § 17705.03 (2024).)

The buyer at the foreclosure sale—often the creditor, the LLC, or other members of the LLC—becomes the permanent owner of all the member's financial rights. Again, the owner of the member's financial rights can both:

• receive money from the LLC, and
• obtain a share of the LLC's assets if it's dissolved.

However, the buyer can't participate in the management of the LLC or order that any distributions of money or property be made.

As a practical matter, getting a member-debtor's LLC interest foreclosed upon can be an expensive and difficult undertaking; but, the ability to do so gives a creditor more leverage in dealing with the debtor. Often, the indebted member or other LLC members will settle the claim to prevent the foreclosure.

Let's return to our previous example: Again, the debt collection agency obtains a $38,000 judgment against John, co-owner of the web design LLC, for his unpaid credit card debts. The California court orders the LLC to pay over to the agency any profits the LLC distributes to John, up to $50,000. However, the LLC need not, and does not, make any distributions, so the agency gets nothing.

The agency then obtains a court order to foreclose on John's interest in the LLC. The agency argues that the LLC won't make distributions and thus the debt won't be paid off in a reasonable time. To avoid the foreclosure, the LLC settles John's personal debt with the agency for $38,000.

Judgment Creditor Can't Dissolve the LLC

Like most states, California doesn't permit personal creditors of an LLC member to have a court order that the LLC be dissolved and its assets sold to pay off the creditor. So, fortunately for you and your fellow LLC owners, you don't need to worry about your company involuntarily closing due to your personal debt.

What About Single-Member California LLCs?

The reason personal creditors of individual LLC owners are limited to a charging order or foreclosure is to protect the other members (owners) of the LLC. It doesn't seem fair that the other members should suffer because one of the members incurred personal debts that had nothing to do with their LLC. Thus, such personal creditors aren't permitted to:

• take over the indebted member's LLC interest and join in the management of the LLC, or
• have the LLC dissolved and its assets sold without the other members' consent.

However, this rationale disappears when the LLC has only one member (owner) and is classified as a "single-member LLC" (SMLLC). As a result, court decisions and LLC laws in some states make a distinction between multi-member and single-member LLCs. California isn't one of these states.

How California Law Treats Multi-Member vs. Single-Member LLCs

California's LLC laws don't distinguish between multi-member LLCs and SMLLCs. Nevertheless, whether, and to what extent, California SMLLCs are protected from outside creditors isn't entirely clear.

Moreover, in some cases, the laws of other states that provide less protection to SMLLCs can be applied—for example, where a California SMLLC does business or owns property in another state. In addition, the protections that state LLC laws provide to SMLLCs might be ignored by the federal bankruptcy courts if the SMLLC owner files for bankruptcy.

Consider Forming or Converting to a Multi-Member LLC

If you're really concerned about protecting the assets in your California SMLLC against personal creditors, you should consider adding another member to your LLC. If you decide to do this, the second member must be treated as a legitimate co-owner of the LLC. If the second owner is added merely on paper as a sham, the courts will likely treat the LLC as an SMLLC.

If you want the second member to be seen as a legitimate owner, you must treat the co-owner like a real LLC member. In other words, the LLC owner must:

• receive financial statements
• participate in decision-making, and
• receive a share of the LLC profits equal to the membership percentage owned.

The new owner must also pay fair market value for the LLC interest they acquire. They can't simply pay a dollar or other nominal fee that doesn't translate to the interest's actual worth.

You can avoid the second member exerting control over the daily operations of the company by setting up a manager-managed LLC and naming yourself as the sole manager. In a manager-managed LLC, the manager makes the operational decisions for the LLC, including striking business deals and binding the LLC to business contracts. The non-manager members take a more passive role and usually just collect their distributions without directly involving themselves in the business. You can define these member and manager roles in an LLC operating agreement.

Should You Consider Forming Your LLC in Another State?

You don't have to form your LLC in California even if it's the state where you live or do business. You can form an LLC in any state. For instance, even though your main office is in California, you could form an LLC in Nevada because it has very debtor-friendly LLC laws.

As a general rule, the formation state's LLC laws will govern your LLC. Thus, forming an LLC in a state with favorable LLCs law could provide you with more limited liability protection than forming your LLC in California. However, creating your LLC in another state will increase your costs because you'll have to pay both:

• the fees to form your LLC in the other state, and
• the fees to register to do business in California.

So should you shop around for the state that provides the most limited liability to LLC owners? If limiting liability is extremely important to you, you might want to form your LLC in a state like Nevada, Delaware, or Wyoming. These states generally have very debtor-friendly LLC laws. But there's no guarantee that California or courts in other states will always apply the law of the state where you formed your LLC, rather than the less favorable California LLC law.

Determining which state's laws will apply is a complex legal issue with no definitive answer. You should consult an experienced business lawyer for more information.

More Information on California LLCs and Liability Protection

As a California LLC owner, you'll want to be aware of your legal obligations, including your company's ongoing legal requirements. For more tips and guidance on running your LLC, check out our articles about:

• California business licenses
• LLC biennial report and tax filing requirements in California
• how to convert your LLC to a corporation in California
• how to start a California business, and
• how to sell a business in California.

You might also be interested in the Starting a Business in California section of our website. This section provides guidance on starting different kinds of businesses in the state, including a restaurant, a child care business, and a marijuana dispensary, among others.

You should also check out our section on LLCs and asset protection. This section has articles on strategies to strengthen your LLC's asset protection and when you might be personally liable for LLC debts.

If you have specific legal questions or a particularly complicated debt or liability issue, you should speak with a California business attorney. They can answer questions specific to your legal situation and help you develop a plan to tackle your personal debt and protect your business.