Fred Witt PLC, Phoenix Federal Tax Attorney
   

August 2014

LLC Alert: Can a Bankruptcy Trustee Be the Newest Member of Your LLC?

Don't be blindsided by an individual member's bankruptcy.

Fred Witt

 

Fred Witt

 

Is it possible that something as remote as a bankruptcy petition filed by one member can wreak havoc with your LLC?

Generally, an LLC is a hybrid entity that has some characteristics of a corporation, yet is treated as a partnership for federal, state and local tax purposes and for determining the existence of federal district court jurisdiction (see related article), among others. Treatment as a partnership adds enormous complexity that can be ignored at the LLC's peril.

Overlay the possible implications of the LLC or a member filing a bankruptcy petition, and the problems and risks multiply exponentially.

If an individual member files a chapter 7 bankruptcy petition, I can think of two misconceptions when LLCs and the bankruptcy courts collide over the LLC member's bundle of economic/voting/management rights:

  • The clauses/restrictions/limitations in an LLC operating agreement that become effective on, or triggered by, the filing of a bankruptcy petition are valid, binding and enforceable in bankruptcy court.

  • When an individual member files a personal bankruptcy petition, (a) a member's LLC interest will not become property of the bankruptcy estate, subject to the powers of a chapter 7 trustee; (b) even if a member's interest is property, a chapter 7 trustee will be prevented from taking any action as a member because of the limitations/restrictions found in the LLC's operating agreement; and (c) no bankruptcy court in Arizona has allowed a trustee to step in and exercise member powers.

The answers — and the powers of the bankruptcy court — may surprise. My next LLC Alert will explain.

Don't be blindsided by an individual member's bankruptcy.