What Led to the Need for the LLC?
Unlike most of the common business entities that exist today, the LLC has a fairly brief history in the United States. Entities such as partnerships, sole proprietorships and corporations have existed since the founding of the country. The LLC, however, has only existed in a recognizable form for roughly thirty-five years. What, then, led to the creation of this new entity? The single most important reason for the creation of the LLC was what has come to be known as "the tax-shield conundrum."
This was a problem created from two interests that traditionally have been in competition with one another. On the one side is the tax issue. More often than not, it is best for a business to be treated as a partnership for tax purposes. This is because the IRS allows the profits from the business, then, to be taxed to the owner or owners of the business. Incorporation is often less desirable from a tax viewpoint because the corporation is treated as an artificial individual. This means that the corporation will be taxed itself for any profits made and then stockholders will also be taxed on any dividends paid to them. The desire to avoid this double taxation provides one half of "the tax-shield conundrum"; the other is the desire to be shielded from liability.
While both partnerships and sole proprietorships provide important tax benefits, they also carry what can be a serious down side. In each case, the owner or owners of the business are personally liable for the obligations of the business. This can include everything from debts incurred in starting the business, to payroll, to lawsuits, and beyond. Corporations, however, do not share this trait of personal liability for the owners. A corporation is legally deemed to be an entity unto itself and as such, any liability incurred by the corporation will not generally pass on to the owners. This desire to be shielded from personal liability is what creates the second half of "the tax-shield conundrum."
There was a great desire in the business community, especially the small business community, to have a business entity that could address both of these needs simultaneously.
The LLC is Born
The Kintner Regulations were the IRS' method for determining what a business entity should be taxed as, partnership or corporation. These regulations determined the taxation of a business entity by looking to a set of four factors. These factors were: (i) limited liability; (ii) continuity of life; (iii) free transferability of ownership; and (iv) centralized management. The IRS compared these four factors to the features of any given business in order to determine tax liability. The IRS held that in order to be considered a corporation, the entity in question must meet at least three of the four factors. By making limited liability simply one of a number of possible features of a corporate entity, the IRS had given states a tool to answer the tax-shield conundrum. With this system in place it was only a matter of time until one of the states exploited this weakness.
It was finally in 1977 that Wyoming took the first step to create the modern LLC. The Wyoming legislature became the first to take advantage of the weakness that was hiding within the Kintner Regulations and passed The Wyoming LLC Act. This act created a new form of business entity that had the liability shield innate to a corporation while maintaining the management, continuity and transferability of the partnership. The Wyoming legislature gambled that an entity that failed three of the four factors in the Kintner Regulations would be passed over by the IRS. Wyoming would not get its answer for ten years.
Apart from the likes of Florida, which copied Wyoming's LLC statute in 1982, most states held off from created an LLC statute of their own until the IRS decided to finally weigh in. It wasn’t until 1987, ten years after Wyoming’s statute, that the IRS finally made a decision on how this new entity would be treated. In Revenue Procedure 88-76 the IRS finally classified this new entity as a partnership for tax purposes. With the IRS now having given its blessing, legislatures across the nation were quick to enact laws of their own which would create LLCs.
Given the basis of these early LLCs as a reaction to the IRS' regulations, it should come as little surprise that there are great differences between those early LLCs and their modern incarnation. While there was much diversity in the specifics of the various LLC legislation, there were similarities due to their birth as a reaction to an arcane set of IRS regulations. These new LLCs tended to have more in common with partnerships than more modern LLCs do. Early on LLCs tended to be only member managed, have dissolution upon the dissociation of a member and strict limits on the transferability of membership. All of these traits were due to the nature of the early LLC as a reaction to avoiding the hammer that the Kintner Regulations could bring down. Over time LLCs saw an increase in diversity as it became clear that the IRS would not strictly enforce the Kintner Regulations on these new entities.
This came to a head in 1997, when the IRS officially did away with the Kintner Regulations in favor of a "check-the-box" tax classification. Under this new classification a business that was organized under a corporate or joint stock statute would be taxed as a corporation while all else would be taxed as a partnership unless stated otherwise. This, in large part, was the final piece of the puzzle. By finally unchaining the LLC from the archaic Kintner Regulations, the IRS allowed the LLC to move far further from its roots in partnership law, bringing it to the partnership-corporate hybrid that we see today.