This is a controversial issue, with Proponents and Opponents on both sides. This is my opinion after researching the topic. However, let’s first look back into history regarding the LLC.
The Family Limited Partnership has been used in many jurisdictions for many years. This entity has been used as an excellent asset protection entity in most states for many, many years. The one issue that some would have with the Family Limited Partnership (FLP), or just Limited Partnership (LP) is the fact that the Limited Partners could be protected from creditors, with what is called the Charging Order Rule, but there was the liability issue of the General Partner, or Partners. However, that power is many times more an opportunity than an actual implementation. We have rarely seen a creditor move for a Charging Order, partly because such a creditor will be hit with phantom income from the California LLC or FLP, and that is a painful cost for the creditor to bear: taxable income without cash.
Unfortunately, from time to time, the courts would allow creditors to come after the General Partners. Over the years, we would work to limit this issue by issuing only a small piece of the Limited Partnership to the General Partner or other such tactics. Unfortunately, the courts, currently, are now much more frequently allowing creditors to bring their judgements against these General Partners, which has caused us to take different tactics.
Then, an entity called a Limited Liability Company (LLC), (not Limited Liability Corporation) was created to eliminate the “General Partner” potential liability issue. Now, in most states, the LLC affords the same Charging Order benefits to all members as does the LP, and since there is no General Partner, as in the LP, that liability issue is reduced, if not eliminated, significantly.
In 1997, after almost all other states had adopted LLC rules, California adopted its own LLC rules and allowed a selected number and type of business to use this new business entity. The whole legal community was excited to finally have in our own state what others had been able to use for years.
However, when we received the new regulations about how LLCs would be able to be used in California, many were disappointed. Not to mention Gross Revenues Taxes and limitations on what kind of business could use it. Liability benefits were not up to what many of us were hoping for. Such as, if you have an interest in a California LLC and a creditor comes after you with a judgment, the first step the creditor must take is to get the judge to issue a Charging Order. That means that your membership interest in the California LLC is charged with the payment of the creditor’s judgment. Of course, since you and your family control the California LLC, you would cut back or eliminate any LLC distributions of profits so that the creditor gets little or nothing, and the Charging Order will remain unsatisfied. In other words, you control what the creditor will get paid.
One major problem with the California LLC is that there is another theory of recovery. In actuality, the judgment creditor in California can ask the court to allow the creditor to foreclose on the membership interest. So a California LLC would not have the charging order protection, but could possibly close down and the assets in the partnership made available to the creditor. By contrast, the laws of 15 other states, such as Nevada, Delaware, South Dakota and Wyoming, only allow the creditor to get a charging order. So, in actuality, creditors in California have more power over LLCs then in some other states.
This, in conjunction with the other issues with a California LLC, law forces us, when determining in what jurisdiction to form our LLC, to remember: A California LLC may not provide the charging order protection we may desire, whereas 15 other states do offer such protection.
There is also the argument that Charging Order protection follows an individual; not the LLC or jurisdiction where it is created. In such a case, a California resident would not acquire Nevada charging order protections by forming an Nevada LLC. Under this argument, only Nevada residents would be entitled to the charging order prote