LLC Bankruptcy Laws

As a relatively new type of business entity, Limited Liability Corporations (LLC) are not expressly addressed in most bankruptcy codes and laws. Therefore, many LLC owners are uncertain how their bankruptcies will be treated in court. Case law has held that an LLC is a hybrid between a corporation and a partnership. Usually, bankruptcy courts treat an LLC with a single owner like a partnership. In this case, the LLC will be dissolved and the business assets are distributed to the creditors. (See also Bankruptcy Filing for Incorporated Entity).

LLC Bankruptcy - Partnership or Corporation?

When an LLC has a single owner, the bankruptcy court may handle the case as either a partnership or a corporation. In the first case, if the judge treats the LLC like a partnership, the court will dissolve the LLC and distribute all assets to its creditors. If any assets remain after this distribution, they will go to the owner. Conversely, if the court treats the LLC as a corporation, the LLC will not be dissolved. Instead, the owner may be allowed to transfer his or her ownership interest to another. However, if the former owner decides not to do this, the bankruptcy court can decide to treat the owner as if he or she is a corporate shareholder. In this case, the owner will be treated as any other shareholder in a bankruptcy case and will not have to relinquish any stockholdings.

LLC Bankruptcy Legalities

Because LLCs are not specifically addressed in the Bankruptcy code, bankruptcy courts often look to state laws to determine whether dissolution occurs upon the bankruptcy of the sole member. One such state law is the Delaware LLC Act (DLLC). Under the DLLC, an LLC whose member files for bankruptcy would be treated as a corporation with a bankrupt shareholder and the bankruptcy would not result in a dissolution as mentioned above. This is true even where the last remaining member files bankruptcy.

Courts also look at the Bankruptcy Code to determine which factors of either a partnership or a corporation may apply in an LLC bankruptcy. For example, the authorization for a member to file a voluntary bankruptcy petition depends on if the LLC is treated as a partnership or a corporation, and the court's determination depends on whether the LLC is managed by its members or has a designated manager. If the LLC is member-managed and the court decides to treat it as a partnership under the Code, all members are required to consent to the bankruptcy filing. When the LLC is managed by one or more designated managers, the determination is not as clear, especially absent any specific provisions within the LLC’s operating agreement as to who has authorization to file a bankruptcy proceeding. It is important that LLC agreements specify provisions regarding who and who does not have authorization to file for bankruptcy.

Whether an LLC can contest the filing of an involuntary Chapter 7 or Chapter 11 bankruptcy petition or convert a Chapter 11 to a Chapter 7 proceeding depends on whether a court determines that the LLC is not a "person" as defined under Section 101(41) of the Code. Additionally, if an LLC is treated as a corporation, only creditors are permitted to file an involuntary petition; individual members would not be allowed to file an involuntary proceeding.

Talk with an Attorney

An LLC bankruptcy is complicated as there are no set laws or rules to determine whether the LLC will be treated as a partnership or a corporation. Rules for both vary and may determine who may initiate a bankruptcy action. Talk with an experienced bankruptcy attorney to discuss how to proceed.