The invention of the LLC, a business structure that has helped small businesses immensely, is a tale of multinational energy companies, powerful trust funds, and tax codes that are slow to change. Wyoming revolutionized how small businesses are formed and operated when it passed a law creating the limited liability company, or LLC, back in 1977. Today, this is the most popular form of incorporation for all sorts of businesses. However, when the law was first passed, it wasn't widely accepted. It wasn't until the mid-1990s that the LLC gained wide acceptance and began growing in popularity.
The History of Corporate Structures
Until the invention of the LLC, businesses only had two choices when it came to their basic structure. The first option was that a business could run and be taxed under the owner's name and identity. The good thing about this option was that it meant that the owners had to pay taxes on their profits once, as income. The downside to this was that it left the owner completely liable: All of the business's debts were completely tied to the owners. If an employee or visitor to the business was injured, the owner was completely vulnerable. The other choice was to file paperwork making the business a C corporation. A C-corp offered limited liability to the owners of the company. The downside is taxation. Larger companies have ways under the laws governing C-corps to lessen their tax burdens via investment strategies, but smaller businesses did not have those advantages. This meant that their owners were being taxed twice: They were paying corporate taxes on their profits and paying taxes as an individual on their personal share of the profits. Some companies would become an S-corp, which would lessen the tax burden while still providing the limited liability of a corporate structure. However, that was a relatively small number of businesses.
A company called Hamilton Brothers Oil Company noticed the gaps in protection caused by the conflict between existing laws and what business owners needed. Hamilton Brothers did business in several countries that did offer a variety of limited liability structures that offered the company tax advantages (known as pass-through taxation) and legal limited liability protection. The attorneys working for the company were concerned that the United States government would not recognize these protections, however. Historically, companies had formed limited partnerships (LP) in these situations. However, the general partners in an LP aren't covered by limited liability.
The lawyers and accountants who worked for Hamilton Brothers began outlining a type of corporation that was missing under United States law, one that offered both tax advantages and legal protection. Eventually, they took their proposal to a state they thought would be open to the idea, since several oil companies were headquartered in the state: They went to Alaska. Twice, the Alaskan legislature voted on the measure but failed to pass it. The company then took the proposal to Wyoming, which passed it on the first try. LLCs were now a legal corporate structure in the United States.
The IRS Weighs In
Companies could now register as LLCs in Wyoming, and the first one did so in 1977. However, the IRS said that it would need two years to decide how this new corporate structure fit into existing tax laws. They issued their first decision in 1980, stating that LLCs would be taxed as corporations. Actually, the 1980 decision stated that any entity operating under limited liability would be taxed as a corporation. This meant that entities like trusts, which so far hadn't been taxed as corporations, now would be. Law firms in New York that represented large, powerful trusts got to work preparing to fight the IRS to protect their clients. It was their effort to protect trust funds that led to the IRS issuing a new decision: In 1988, the IRS stated that LLCs would be taxed as a traditional partnership while still offering the owners of the LLC liability protection.
LLCs Gain Popularity
Once the IRS released its 1988 decision, other states began legalizing LLCs. However, there was an issue with the way the Wyoming law had been written back in 1977. The 1977 law created what today is known as a Wyoming Close LLC. This type of LLC limited how members could transfer assets and also stated that the company would persist in perpetuity. Business owners needed an LLC that was slightly more flexible and could cease existence, but changing the structure would mean that the IRS could revoke its 1988 tax decision. From 1988 to 1990, a group of ten attorneys volunteered to meet weekly to work on a prototype LLC act that all states could use to legalize the business structure in their state. This LLC act would provide more flexibility than the initial Wyoming LLC laws and yet still meet with IRS approval. The group, which worked under the American Bar Association, met regularly with attorneys from the IRS to make sure the IRS would approve of these changes. The IRS was slow to agree, but by 1994, when half of all states had codified LLCs into their laws, the IRS finally agreed and issued an updated decision that reflected the provisions of the prototype LLC act the attorneys had worked on. After all 50 states had passed their version of the LLC act in 1996, the IRS released a final decision on LLCs. Those are the tax rules that are still in force today.
- The Story of LLCs: Combining the Best Features of a Flawed Business Tax Structure
- Small-Business History: Where LLCs Come From
- Limited Liability in Historical Perspective
- Limited Liability Company (LLC)
- What Is an LLC?
- How to Form a Limited Liability Company
- What Is a Limited Liability Company (LLC)? Definition, Pros, and Cons
- What Is an LLC?
- Considerations in Forming a Limited Liability Company
- Selecting a Business Structure
- Choose a Business Structure
- LLC vs. S Corporation: What's the Difference?
- Choose Your Business Structure
- Should I Form a Corporation or an LLC? What's the Point?
- Wyoming Administrative Rules: Limited Liability Company
- Why Form an LLC in Wyoming?
- Should You Form an LLC for Your Small Business?
- What Is the Difference Between a Shareholder vs. an LLC Member?
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