back to articles/index As appearing in... February 16, 2011

A recent Florida Supreme Court decision has potentially weakened the protection offered real estate investors by Limited Liability Companies (or "LLCs"). While this affects many of my clients, it has importance beyond 1031 exchanges. If you or your client holds investment property in an LLC, this article is a must-read for you.

by Gary Gorman founding partner, 1031 Exchange Experts, LLC

But first, a little background...
There are two types of LLC creditors. Inside creditors are those who can sue your LLC, but not you as an owner. Someone who falls and gets hurt on your LLC's property can only sue the LLC and not you. Your residence and other personal assets are protected from inside creditors. Outside creditors are those who can sue you, but cannot take over your ownership interest in your LLC or take an asset owned by your LLC. For example, if someone sues you because you caused a car accident, they cannot be awarded your investment in the LLC, nor can they take an asset owned by the LLC. The LLC's assets are protected from outside creditors, and if your LLC is sued, the best your adversary can hope for is to get a charging order. A charging order only gives the creditor the right to any distributions of profit from the LLC; they don't have the right to any cash distributions if you choose not to make any—and they can't force you to.

Since profit distributions are taxable, this puts the outside creditor in the worst possible situation: you can let the cash build up in the LLC while the creditor pays tax on it—the creditor is paying the tax on your cash! As a result, the last thing a creditor wants is a charging order against your LLC.

The purpose of LLC charging orders is to protect the other members of the LLC not involved in the suit. Obtaining the debtor's actual membership interest or the actual ownership of the LLC's assets could adversely affect the other members of the LLC. The foundation of LLC law is to not force the other members of the LLC to accept the creditor as a new member. So until now, a debtor's investments in LLCs were considered untouchable.

This comfortable level of protection may soon be gone. A recent Florida Supreme Court ruling found that charging order protection was not applicable in the case of a single member LLC, meaning it has one owner. The court allowed an outside creditor to take ownership of several LLCs owned by the defendant, thereby gaining ownership of the assets owned by the LLCs. This creditor's argument, with which the Court agreed, was that the creditor should get ownership of the single member LLC (and thereby the assets of the LLC) rather than a charging order since there were no other members to protect. The argument goes that no innocent partners would be adversely affected if the creditor were given the LLC interest.

What does this mean to you?
If you hold property in a single member LLC believing you have protected the property from outside creditors, you'd better think again. While this is a Florida case, it's not hard to imagine an aggressive attorney in your state using the same logic to go after your LLC interest or it's assets.

What if you and your spouse are the only members of the LLC? Again, it's only a small leap to imagine an aggressive outside creditor's attorney arguing that they should get your LLC since there are no other members for the court to consider. If you live in a community property state, such as Arizona, they would have an even easier time making this argument since community property states treat married couples as a single entity. But now couples in any state are at risk.

So what can you do about it? The simplest protection would be to add another member to your LLC (or a third member if the only members are you and your spouse) so that there is an unrelated party whose investment the court would need to protect. I expect that as asset protection attorneys begin to wake up to this problem there will be lots of other solutions proposed; possibly setting up a trust and using it as the other member. But I encourage you to do as I'm doing: add another party to the ownership of your single member LLC, and/or your spouse-co-owned LLCs.