On September 1, 2023, Senate Bill 2314 became law and changed the landscape of asset protection for small business owners across the state of Texas.  But this significant change in the law seems to have slipped under the radar.  Owners of single-member LLCs now enjoy the same protection from creditors that owners of multi-member LLCs have had for years.  Seems like cause for celebration, right?  Absolutely.  So why didn’t this announcement make the big splash it deserved?

In large part because most business owners assumed the protections given multi-member LLCs were available to single-member LLCs too.  After all, the statute didn’t delineate any differences between the two types of LLCs.  But not so fast.  Some crafty attorneys, in their never-ending search for loopholes, made the argument that single-member LLCs were basically the same as sole proprietors and shouldn’t be afforded the same protections as multi-member LLCs.  Enough judges listened, and just like that, a gray area was born.

Attorneys love gray areas.  Business owners, not so much.  The debate has raged on in the courts for years, mostly out of earshot of the general public, and many small business owners have suffered the consequences of choosing the single-member LLC as the structure of their business.

But finally their hero arrived, and with the stroke of a pen, the legislature answered Texas small business owners’ cries for help.  Now the personal assets of all Texas LLC owners, whether single-member or multi-member, are safe from creditor attack.  Whew.  But how did we get here?

Let’s start from the beginning

Limited liability companies (LLCs) are arguably the most popular business entity among entrepreneurs, and for good reason.  They offer their members protection from the company’s creditors, tax advantages, and ease of administration.  There are two types of LLCs: single-member LLCs (where one person owns the business) and multi-member LLCs (where more than one person or entity owns the business).

If an LLC is sued, the assets of the business can be seized by its creditors, but the personal assets of the owners are safeguarded from such an attack – or at least that was the intent when the law was created.  However, if an LLC member is sued for personal reasons unrelated to the company, Texas law provides that while a member’s ownership interest in the LLC cannot be seized, the creditor can secure a lien against the owner’s financial interest in the LLC.  In fact, the Texas legislature clarified the law by amending it to read definitively that this lien, called a “charging order,” is the only remedy available to creditors of both single-member and multi-member LLCs in these situations.

What is a charging order?

As mentioned above, if a creditor obtains a judgment against an LLC member, the member’s personal assets are indeed protected from seizure.  But a charging order, issued by the court, allows a creditor to obtain the LLC owner-debtor’s financial rights in the LLC – in other words, it acts like a lien on the member’s LLC ownership interest.  But there are limits to the charging order.  The creditor may not participate in the LLC’s management, force the LLC to make a distribution to the creditor, or order that the LLC be sold to pay off the creditor’s debt.

The rationale behind these limitations is to avoid disruption to the LLC’s operation, since the creditor’s beef was with an LLC member, not the LLC itself.  This ensures that a member’s business is not interrupted to satisfy a debt unrelated to the business, and that hard-earned company assets are not lost in the turmoil.

Naturally, creditors don’t like this outcome, and that’s why they argued against this protection for single-member LLCs when the gray area was discovered.  However, all is not lost for the creditor.  The charging order allows the creditor to receive any distributions that would be made to the debtor-member going forward.  Good news for the creditor, right?  But unless the LLC elects to make distributions, and because the creditor cannot force the LLC to make distributions, the charging order has little or no value to the creditor.  Foiled again.

A real world example

So how does this play out in the world of the single-member LLC owner now that the law has changed?  Let’s assume a creditor obtains a judgment against Dan, who happens to be the sole member of ABC, LLC, a company Dan started years earlier to offer handyman services.  The business has done well under Dan’s management and now owns a couple million dollars’ worth of various assets.  The creditor’s lawsuit stemmed from an unfortunately serious auto accident that happened on Dan’s personal time.  Dan is underinsured, so the creditor seeks compensation directly from him.

Dan has no non-exempt personal assets, so no luck there for the creditor.  But the creditor sets its eyes on Dan’s ownership in ABC, LLC.  Before September 2023, courts in various jurisdictions would have allowed the creditor to seize Dan’s ownership interest and liquidated the company to satisfy its debt.  And all of Dan’s hard work over the years might have vanished into the pockets of his creditor.

But now the creditor is left to exercise its only option – it obtains a charging order and is now entitled to any distributions that would otherwise be made to Dan as the sole member.  However, since the creditor has no management rights in the LLC, Dan retains control over all distributions.  He may choose not to make any distributions while the charging order is in effect, and the creditor would be out of luck.

But wait, there’s more!  Since Dan’s single-member LLC has elected S-Corp tax status, all the income of ABC, LLC flows through to Dan’s personal income tax return.  However, while the charging order is in place, the IRS considers the creditor to be the assignee of the income normally reported on Dan’s return.  So, incredibly, the creditor becomes responsible for paying taxes on the LLC’s income, even if the LLC never makes any distributions.  You can only imagine the creditor’s frustration.  In fact, the tax issue alone is enough to dissuade creditors from even obtaining the charging order in the first place.

That’s why this change in the law is such a resounding victory for single-member LLC owners.  It reaffirms the LLC as a valuable tool for protecting the assets of small business owners across Texas, who can once again concentrate on building value in their companies without the threat of big creditors ripping it all away.

Remember, asset protection is not just for the wealthy.  It’s an essential financial strategy that everyone should employ, whether you’re a sole owner or a large corporation.  If you think a single-member LLC is right for you, give us a call.  We’ll be happy to discuss the pros and cons and set it up for you.