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Bean Law Blog

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Birth of the Limited Liability Company

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We’re all familiar with them by now, limited liability companies (“LLC”), but not long ago, they didn’t even exist. It used to be if you wanted to start a business, you opened your doors as a sole proprietor, formed a partnership, or if you were really fancy, started a corporation. Today, however, LLCs have left these business models in the dust. It is far and away the entity of choice and the impact on the small to medium size business world has been immeasurable.

Let’s rewind to when it got started. It was 1977, in Wyoming of all places, that legislation first gained traction and the new business entity was adopted. Alaska had previously tried to pass similar legislation but failed. Wyoming legislators, however, much to their credit, saw the opportunity to stimulate business growth and wasted no time adopting the new entity. They were also seeking to attract out of state capital.

The advent of Wyoming’s LLC laws did not mean business owners raced to form an LLC, nor did other states pass similar legislation right away. Instead, business owners and states largely spent the next decade on the sideline waiting for the Internal Revenue Service (IRS) to make up its mind on how an LLC would be taxed. Business owners, corporations and high powered law firms advocated that LLCs should be taxed like a partnership, and the IRS felt they should be taxed like a corporation. Finally, in 1988, the IRS determined that LLCs would be taxed as a partnership.

Following the IRS decision, the time was finally right for other states to get on board. Fittingly, it was Delaware, an already progressive leader in corporate legislation, that led the charge. In 1992, Delaware passed the Delaware LLC Act, a comprehensive body of law that other states could adopt and follow. Among these states was Idaho. Idaho passed the Limited Liability Company Act in 1994, which was subsequently replaced by the Idaho Uniform Limited Liability Company Act.

So, what’s the big deal? Why has the introduction of this new entity been so important? Before the LLC, small and medium-sized business owners, entrepreneurs and startups would have to form a corporation if they wanted to enjoy the privilege of limited liability protection. For many, forming a corporation was not practical or just didn’t make sense. Unlike an LLC, corporate formalities make day-to-day operations more cumbersome, require a board of directors, and the directors must answer to shareholders. Still, corporate owners could operate without fear of being sued in their personal capacities.

LLCs offered small and medium-sized business owners a new way of doing business that didn’t require them to gamble their personal assets, it was a momentous shift that has had a huge impact on the business community. Granting business owners a practical means of limiting their personal liability was a policy decision that rewarded these same owners for taking a risk that could ultimately benefit the community at large.

In addition to insulating its owners from personal liability, LLCs are significantly less complicated than a corporation and allows its members to mold the LLC structure in a way that best suits its business model. It also contemplates a much smaller ownership group that doesn’t have to pass corporate resolutions, answer to shareholders, and in some states, even hold an annual meeting. Aside from filing an annual report to stay current with its state’s secretary of state, the corporate formalities are minimal. An LLC however, should adopt an operating agreement that works best for its business model, which will also serve as a road map for its operations and a contract between its members and the LLC.

It should come as no surprise given the amount of time it took for the IRS to make up its mind, that perhaps the most significant benefit of an LLC, other than its limited liability, is its tax treatment. An LLC is taxed as a partnership making it a pass-through entity. Unlike a corporation, which is taxed at the corporate level and then at the individual level (double taxation), an LLC is only taxed once. Whatever is made at the LLC or company level, passes through to the individual level and is only taxed once. Consequently, an LLC has the advantage of a corporation’s limited liability status and partnership tax treatment.

Birth of Limited Liability Companies

Given its simplified nature, limited liability, and pass-through tax treatment, it’s no wonder that an entity introduced just a few decades ago now counts for every two out of three businesses formed in the United States. Inherent in its youth, however, is its limited battleground experience within our court system. Corporations have been tested for decades now by case after case, whereas case law is still somewhat limited in the area of LLCs. Nevertheless, in an age of start-ups and entrepreneurship, LLCs offer a great means for pursuing a business dream without placing all your chips on the table and is certain to remain the business entity of choice for decades to come.

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