Fred Witt PLC, Phoenix Federal Tax Attorney
   

August 2014

LLC Alert: Will a Bankruptcy Trustee Enjoy the Privileges of LLC Membership?

An Arizona bankruptcy court had little difficulty bulldozing conventional wisdom and granting extraordinary rights and powers to an unknown chapter 7 trustee.

Fred Witt

 

Fred Witt

 

When an LLC collides with the bankruptcy court, is it possible that an ironclad entity may look more like an egg shell? Is there a bankruptcy chink in the LLC armor?

Surely, this cannot be. If a member files a personal chapter 7 bankruptcy petition, conventional wisdom dictates that the member's chapter 7 trustee will, at most, be a "transferee" of the member's economic interest with a right only to distributions (if and when they occur). Nothing else happens. Nothing more to the story and nothing for LLCs to worry about, right? Those from the "show me" state would demand to see the case.

In In re Ehmann, 319 B.R. 200 (Bankr. D. Ariz. 2005), the bankruptcy court held, with respect to an interest in a multi-member Arizona LLC formed by the debtor's parents:

  • The LLC interest is a "property" right giving the chapter 7 trustee broad powers.

  • Because the LLC interest is "property" of the estate, state law and contract law restrictions and limitations are unenforceable against the trustee.

  • The trustee has all of the rights and powers the debtor had as a member.

  • Appropriate remedies available to the trustee include, among others, an appointment of a receiver to take over and operate the LLC and even the dissolution and liquidation of the entity.

While the dispute was eventually settled (and subsequent order withdrawn, 337 B.R. 228 [2006]), this bankruptcy court had little difficulty bulldozing conventional wisdom and granting extraordinary rights and powers to an unknown chapter 7 trustee.

Don't be blindsided by a member's bankruptcy. Is a solution possible? For an answer, see the next LLC Alert.