From its humble beginnings in the 1970s, the limited liability company (LLC) has quickly become the most popular form of business entity in the United States.
Attorneys and small business owners across the nation praise the LLC for allowing small businesses to gain the advantages of limited liability while retaining a great deal of flexibility in their governing structure. As a result, more LLCs are formed across the nation than any other entity. But what began this revolution in American business?
Wyoming created the first statute allowing for the creation of LLCs in 1977. Wyoming’s statute was partly based upon a German company form that was first created in 1892 and spread to many parts of the world. In fact, many American states had been trying to merge the benefits of limited liability with the flexibility of partnerships for many years. Some states created “limited partnership associations” and “limited partnerships” as early as the late 1800s. However, the growth of these entities was limited as the benefits of limited liability only passed to passive investors, not active participants in the business.
Florida was the next state to authorize the creation of LLCs, and many states followed Florida’s lead, including Delaware, one of the most important states in American business law. Nevertheless, many entrepreneurs were wary of the new structure because the IRS did not know how to tax these new entities. LLCs would only be a viable choice for many entrepreneurs if LLCs were taxed like partnerships or pass-through entities. If LLCs were to be taxed as corporations and subject to the “double tax” on corporations, they would immediately lose their appeal in the eyes of many entrepreneurs.
Initially, the IRS privately ruled that LLCs were to be taxed as corporations. This ruling in 1982 severely curtailed the growth of LLCs. Fortunately, the IRS reversed course in 1988, allowing LLCs to be taxed as partnerships if certain formalities were met. In particular, the IRS ruled that it would look at the characteristics of an LLC to determine whether it looks more like a corporation or more like a partnership for purposes of taxation. As a result of this ruling, every state had a statute authorizing LLCs by 1996. However, these statutes varied in terms of how an LLC is to be formed and what formalities must be followed. These variations and complexities made the IRS’s job of determining whether an LLC could be taxed as a partnership nearly impossible. Therefore, the IRS promulgated a new rule and a new scheme in 1997 that allowed LLCs to choose whether to be taxed as a partnership or corporation. At this point, there was no stopping the revolution in the American business world. In less than ten years after this ruling, LLCs were being formed at double the rate of traditional corporations.
Now, entrepreneurs across the United States can and do enjoy the benefits of limited liability and the benefits of being taxed as a pass-through entity. Of course, the LLC form may not be ideal for every business and prospective business owners should consult an attorney before forming an LLC. Nevertheless, from its humble beginnings, the LLC has become a game-changer in the American business world.