This article describes how to use a limited liability company (LLC) as a shield to allow real estate vested in the LLC to remain undisturbed by creditors of members — and how the creditor of an individual LLC member may enforce a money judgment against the debtor member’s ownership interest in the LLC.
Liens against individuals
Consider a broker/owner of a real estate office. The broker employs several sales agents and has continuous access to real estate entering the market for sale. The broker manages the office and sales agents, and periodically meets with clients handled by agents. The broker also occasionally acquires property for their own account as a principal.
Due to the business activities of the sales agents employed by the broker, the broker has liability exposure for the professional errors and misconduct of the broker’s agents. Even though the broker has incorporated their real estate office operations and has errors and omissions (E&O) insurance coverage, their role as the designated officer exposes the broker to personal liability. The broker bears the responsibility for the constant supervision of the sales agents employed by the corporation.
The broker is cognizant of the need to personally maintain a low financial profile to avoid the appearance of a “deep pocket” which might itself trigger litigation. As a result, the broker vests all the real estate the broker personally acquires in separate limited liability companies (LLCs) the broker creates for vesting title to the property acquired.
The broker’s conflicting ownership interest between their brokerage office and any acquisitions handled in the office on behalf of the broker’s LLC vestings is fully disclosed to any seller or buyer with whom the broker or their sales agents have any relationship. [See RPI Form 527]
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Potentially dangerous personal lawsuit
Later, one of the broker’s sales agents commits an error. The broker is faced with a potentially dangerous lawsuit arising out of the sales agent’s misconduct while acting on behalf of the broker, unrelated to any of the broker’s personal real estate acquisitions.
The broker needs assurance the pending litigation, which seeks a money judgment against the broker personally, will not interfere with their ability to manage, sell, mortgage or lease the real estate vested in the broker’s LLCs.
Will a money judgment or lien against an individual member who is an owner of an LLC interfere with the real estate vested in the LLC?
No! Ultimately, only the broker’s “off-record” ownership interest in the LLC can be affected, not the property vested in the LLC. Further, and importantly, the brokers interest as owner of the LLC is personal property, not real property. Thus, the recording of any liens or judgments against the broker will not affect the real estate vested in the LLC — only the broker’s interest as owner of the LLC and only when a charging order is issued by a court. [Calif. Corporations Code §17705.01]
A lien or money judgment against an individual who is a member or manager of an LLC is unrelated to the real estate vested in an LLC. Further, only after a judicial charging order is processed can a money judgment against an individual attach to the individual’s ownership interest as a member in an LLC. No attachments are automatic or permitted by recording of a document. [Corp C §17705.03]
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Interest in the LLC — not the real estate
An individual who is a member of an LLC has no interest in the real estate owned by the LLC. A member’s ownership interest in the LLC is thus classified as personal property. [Corp C §17300]
While a member has no interest in any LLC property, the member is entitled to their share of the LLC’s:
- operating income;
- sales proceeds; and
- assets in the event the LLC is dissolved. [Corp C § 17707.05]
Creditors, judgments and liens
A member in an LLC, such as an LLC solely owned by one individual like a broker, may have an outstanding debt they separately owe due to:
- a money judgment (i.e., lawsuit liability); or
- a local, state, or federal tax lien.
Once recorded, these money judgments or liens automatically attach to any real estate interests vested in the individual’s name or any trust arrangement they have established another person to hold title as a trustee for the true owner of the property. Remember, a trust is not an entity and is not separate from the beneficiary who retains all the rights and benefits of ownership to the property.
However, a money judgment against an LLC member which does not also name the member’s LLC entity as a judgment debtor can only be satisfied by foreclosing on the member’s ownership interest in the LLC — not the real estate owned by the LLC.
Thus, an LLC entity remains unaffected by a lawsuit against an individual member. The LLC, as a separate entity, carries on its normal business activities without interference from a member’s creditor seeking to enforce collection rights under a judgment. [Calif. Code of Civil Procedure §§708.310, 708.320]
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Charging orders to attach a share
Through a money judgment against a member in an LLC, the member’s ownership interest in the LLC may, on discovery of its existence, be attached to satisfy the judgment. This procedure involves the use of a court-ordered judicial attachment device called a charging order. [CCP §708.310]
Under a charging order, a creditor must first locate the LLC interests held by a judgment debtor. Once discovered, the creditor then applies to the court for an order to charge (place a lien on) the ownership interest in the LLC held by the individual member for payment of the judgment. [Corp C §17302]
Notice of the hearing on the charging order is given to the debtor member and all other members of the LLC. [8 CCP §708.320]
A creditor of an individual member has two options to enforce a money judgment:
- appoint a receiver to receive the debtor member’s share of the income and profits generated by operations of the property vested in the name of the LLC; or
- foreclose under the charging order lien on the member’s interest in the LLC, and become the owner of the debtor’s interest. [Corp C §17302]
Under a charging order lien, the appointment of a receiver is restricted to accepting the benefit of the individual member’s interest in the LLC. The creditor acquires no greater rights than the debtor member had under the LLC Articles of Organization or the LLC Operating Agreement. [Corp C §17705.02; See RPI Form 372]
A creditor with a judgment has the judicial means to go after a member’s economic interest only, not the property vested in the LLC. However, the reality of obtaining an individual member’s interest through further litigation is too often more of a hassle than it is worth.
The interest the creditor obtains from the debtor member is a nonvoting interest which prohibits interference with LLC activities requiring a vote. Accordingly, the creditor assumes no duty or liability owed to the LLC or its other members, but has no voice in management of the LLC. [See RPI ebook: Forming Real Estate Syndicates: Chapter 18]
Further, the LLC operating agreement typically provides for removal of the debtor member from the LLC when a charging order against the debtor member’s interest is not immediately removed. [See RPI Form 372 §6.2(d)]
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Buyout provisions triggered
One or all of the members in a LLC may terminate a debtor member’s interest in the LLC on the notice of a charging order without causing the LLC to be dissolved. This right is granted in the LLC operating agreement on terms in its buyout provisions. [See RPI Form 372 §7]
On termination of a member’s interest, the remaining members may buy the terminated member’s entire interest in the LLC. When more than one member exercises their option, those exercising will purchase their pro rata share based on their aggregate ownership interest. [See RPI Form 372 §7.1(b)]
Buyout provisions in an LLC agreement between members are the most common method used for the elimination of a debtor member and their judgment creditor. Additionally, the terms of buyout provisions are usually financially advantageous to the remaining members. [See RPI Form 372 §7]
Fraudulent conveyances by debtors
The transfer of property by an owner of real estate to evade a creditor is considered fraudulent when:
- the owner intends to defraud their creditors; [Calif. Civil Code §3439.04(a)(1)] or
- a reasonably equivalent value is not received by the owner in exchange for the property transferred, and the owner is or will be insolvent (i.e., debts exceed assets) on the transfer. [CC §3439.05]
Any property transfer made for the purpose of avoiding creditors may be invalidated as a fraudulent conveyance. 13
However, when the full value or a reasonably equivalent value is received by an owner for a transfer, the transaction cannot be invalidated. The creditor is then left to chase down and attach the proceeds received by the owner (debtor).
A fraudulent conveyance is indicated when an individual knows of pending litigation or claims against them, then transfers their real estate without receiving fair value.
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Fraudulent conveyance without fair value
Consider an LLC consisting of three members. Later, a judgment is obtained by a creditor against two of the members of the LLC in their individual capacities.
A creditor obtains a charging order against the members’ individual interests in the LLC. All three members receive notice of the proceedings.
Prior to the enforcement of the charging order, the members dissolve the LLC. The two debtor members each transfer their ownership interest to the third member, who is unnamed in the judgment, for a minimal sum, if any.
Here, the transfer is fraudulent since the third member was on notice of the charging order and did not pay a fair value for the transfer by the debtor members. When a transfer is made by an owner without a fair exchange of value to a “buyer” who knew the transfer diminishes the creditor’s claim, the “buyer” then becomes liable for the creditor’s losses. [Taylor v. S & M Lamp Co. (1961) 190 CA2d 700]
Thus, the fraudulent conveyance of a debtor’s “wealth” beyond the reach of a creditor will be subject to disciplinary action from the court.
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The LLC asset shield
The use of an LLC to hold real estate assets was neither designed nor intended to be employed as a place to hide an individual’s personal wealth. Rather, use of an LLC is a means to allow real estate vested in the LLC to remain undisturbed in the face of an individual member’s adversity, and vice versa. A shield, by definition, as the vesting forces the creditor to negotiate a better resolution.
Consider an owner who places their ownership of real estate into an LLC. The owner receives a percentage or all of the ownership interests in the LLC for the conveyance — fair value for the transfer since they became the owner of the LLC which now owns the real estate.
In this instance, the conveyance is not fraudulent. The owner has merely exchanged their interest in the real estate for an interest in the LLC of equal value. Full value is received, and no tax liability is incurred on the exchange. [26 United States Code §721]
In essence, the owner has substituted their real estate vesting for a position in the LLC. The owner still owns a value equal to the equity in the real estate they transferred, only in a different form. Thus, the value of the owner’s interest was not diminished since they received an equivalent value for the property. The nature of the owner’s ownership interest merely changes from one of real property to one of personal property.
However, this simple change in vesting inherently makes it far more difficult for creditors to locate and attach the debtor’s assets, much less collect. The individual owner (debtor) on a recorded abstract of judgment is not the vested owner of any real estate.
Further, the change in vesting makes the real estate, now the asset of an LLC, much more difficult for the creditor to reach due to:
- the charging order process;
- nonvoting status upon ownership by foreclosure; and
- the subject of buyout provisions in the LLC operating agreement at less than the current value.
As the creditor is attempting to locate and attach the debtor’s assets, the LLC continues its business of renting, selling, or encumbering the property. On attaching the member’s interest via a charging order and appointment of a receiver, the LLC distributes income proceeds the debtor member is entitled to receive to the judgment debtor who on foreclosure holds a nonvoting membership share in the LLC.
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