Keeping LLC Liability Protections in Hard Times

For many entrepreneurs, the LLC entity has served them well in the past years. However, circumstances may have changed dramatically in the past months. We are hearing of people whose businesses are unable to get credit necessary for carrying on usual operations. For some business owners this is an inconvenience, as they have other sources of money to advance to the LLC. For others, the unavailability of credit can be a disaster.

Of utmost importance is maintaining the liability shield in order to protect your personal assets from LLC creditors. For general information on protecting your assets, see these other articles in this website:

More specific actions to take or avoid will be discussed below.

It is important to pay all bills of the LLC out of the LLC checking account, not out of the owner’s personal account. Also, income to the LLC should come through the LLC checking account. Keeping these requirements in mind will help preserve the separateness of your LLC entity.

This article assumes the following:

  1. When the LLC was created, it was set up with a reasonable amount of capital investment,
  2. The LLC has been operating for some time, and
  3. The LLC is now facing serious cash flow problems.

If the owner-member decides to continue the operation of the LLC, the owner must be careful about taking cash distributions from the LLC. In Washington, the LLC statutes prohibit a distribution to a member if the LLC, after the distribution, would not be able to pay its debts as they become due in the usual course of business. The same statute prohibits a distribution to a member if the distribution causes the LLC to have a negative net worth (assets are less than liabilities).

The statute has some exceptions, and these can get complicated. So, if you are facing an LLC insolvency, you should talk to your accountant and/or attorney about how to proceed. The statute also states that if a person knowingly makes a distribution in violation of these principles, that person is liable to the LLC for the amount of the distribution.

If an LLC is insolvent and the member or members decide to advance funds to the LLC, the members should consider alternative ways to put money into the LLC while keeping personal assets shielded. If funds are loaned to the LLC, the transaction should be properly documented with a promissory note and, if possible, a security interest. Additional capital can also be contributed to the LLC. These different methods of adding cash to the LLC have different consequences and should be discussed with your accountant and/or attorney.

If it becomes time to terminate the operations of the LLC, note that the Washington statutes are very specific on this process. There is a process for “winding up” the affairs of the LLC, by which the owner(s) may wind up the affairs of the LLC following the statutory requirements. Alternatively, a person can apply to a court for a court-supervised winding up of the company’s affairs. In some cases the LLC owners should consider a federal bankruptcy proceeding to terminate the operations of the LLC.

After the winding up process, the LLC can file a “certificate of cancellation” which will terminate the LLC’s existence. Owners should be very careful about filing a certificate of cancellation because filing a certificate may prevent the LLC from being able to counter-sue or make cross complaints in the event unanticipated claims or lawsuits are made against the LLC. There have been a number of cases in the last couple of years which address the consequences of canceling an LLC when there are still outstanding claims against it.

Many of the principles discussed in this short article on LLCs will be likewise applicable to closely held corporations. But, the details for corporations are in separate statutes, and the principles are similar but not the same.