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.