LLCs are not always Bullet Proof (Part I)

When setting up a new business, many entrepreneurs have been advised to use a limited liability company (“LLC”) as the formation entity of choice because of its limited liability and asset protection features. I’ve heard some business owners even go so far as to refer to LLCs as some kind of bullet-proof vest against creditors’ claims. Accordingly, an entrepreneur may decide to convert her corporation into a LLC and place assets under her newly-converted entity in order to benefit from these protective features.

And yes, a newly-formed and properly maintained LLC can provide limited liability protection to its member(s), protecting them from personal liability for the entity’s obligations. However, simply placing assets under a LLC does not shield the LLC from creditor claims. LLCs are not always bullet proof.

For example, under Texas law, when a corporation converts to a LLC, creditors and third-parties with claims against the corporation (the “converting entity”) can pursue those claims against the newly-converted LLC (the “converted entity”) and its owners/members.

Texas Business Organization Code (TBOC) Section 10.106, subparts 4 and 5 state:

(4) the rights of creditors or other parties with respect to or against the previous owners or members of the converting entity in their capacities as owners or members in existence when the conversion takes effect continue to exist as to those liabilities and obligations and may be enforced by the creditors and obligees as if a conversion had not occurred (italics added);

(5) a proceeding pending by or against the converting entity or by or against any of the converting entity’s owners or members in their capacities as owners or members may be continued by or against the converted entity in the new organizational form and by or against the previous owners or members without a need for substituting a party (italics added).

So, as an entrepreneur sets up a business, he should have a clear understanding of the laws in his state. He should be familiar with how his state (and any other states in which he intends to do business) treat claims against LLCs, newly-formed and converted.

In a later post, I will discuss how states vary on the treatment of claims against single member LLCs vs. multiple member LLCs and a creditor’s ability to pierce the corporate veil of the LLC, hold the LLC’s member(s) personally liable, and reach the assets within those entities.

Stay tuned.

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