October 2004
Volume 1, Number 1
Table of Contents

LLCs: Is the Future Here?
A History and Prognosis

The landscape of business forms has changed in the last 20 years. The irresistible force of state legislatures and lawyers met and ultimately conquered the immovable object of federal tax restrictions on choice of form.

Two business forms dominated at the dawn of the modern era - General partnerships and corporations. General partnerships are the soup-to-nuts of the corporate form, being used by mom-and-pop operations to international accounting firms. In general partnerships, all owners equally share control, profits, losses and partnership property. To address disputes, every partner has the right to dissolve the firm and force the sale of its assets.

With the corporation, shareholders are not liable for corporate debts beyond their investments and they lack the power to unilaterally to dissolve the firm. But these advantages come at the price of an owner-level tax on the firm's distributions on top of the levy on the corporation's earnings. Also, just as the partnership form can be a problem for larger firms, so the corporate form can be a problem for smaller ones. Courts enforced basic form alterations and legislatures offered special models that permitted partnership-type direct management, voting rules and financial sharing.

Despite these changes, the corporate form never forgot its origins as the large business vehicle. Most important, owners might find themselves unhappily stuck in the company with no buyers for their shares and no other possibility of exit unless they could persuade their fellow shareholders to dissolve. Courts and legislatures devised remedies to deal with frozen-in owners, but the remedies either failed to match the flexibility of the partnership form or risked having a court impose relief contrary to the parties’ agreement.

We needed a business form that combined the most useful elements of both partnerships and corporations for closely held firms -- limited liability, partnership default rules and flexibility, and flow-through taxation. In other words, “partneration.”

In the early 1950s, Congress created the Subchapter S corporation, which permitted partnership-type taxation in the corporate form. This enforced simplicity, however, makes Subchapter S a kind of straightjacket, limiting the number and type of members and, most important, confining firms to a single-class capital structure.

States also refined the limited partnership form, which permitted limited liability for passive investors. Though general partners in such firms were liable for partnership debts, they could incorporate, thereby creating what has been called a “corpnership.” At the same time, limited partnerships had the advantage of partnership-type taxation.

However, tax classification rules determined the contractual terms that would make a firm a corporation for tax purposes -- including excessive continuity, transferability and centralization of management. Limited partnerships also had to deal with the state-imposed "control rule," which treated the limited partners as general partners if they participated too heavily in management.

In 1977, Wyoming passed a limited liability company (LLC) statute that had everything partneration fans wanted -- limited liability for all members, partnership features such as dissolution at will and lack of free transferability, and members' ability to participate in control without risking loss of their limited liability. The federal government was reluctant, however, to bless the entity with partnership tax treatment.

On Nov. 17, 1980, the IRS proposed treating LLCs as corporations *12 (45 Fed. Reg. 75,709). The IRS eventually withdrew that proposal in 1983, but privately ruled in 1982 that an LLC would be classified as a corporation ( PLR 8304138 ) and announced in 1983 that it would not issue any more private rulings concerning LLC classification ( Revenue Procedure 83-15 ).

Meanwhile, the pressure for partneration grew. The Tax Reform Act of 1986 provided some impetus by reducing the tax advantages of retaining corporate earnings and thereby increasing the tax incentives for partnership. While LLCs were in abeyance, limited partnerships provided an alternative vehicle for testing tax boundaries. Soon after the temporary defeat of the LLC, the 1985 version of the Revised Uniform Limited Partnership Act was promulgated.

In 1988, the IRS found that a Wyoming LLC could be taxed as a partnership. Revenue Ruling 88-76 . By the end of 1991, Colorado, Kansas, Virginia, Utah, Texas and Nevada had passed LLC statutes. Nevertheless, LLCs still had to play the tax-classification game. This meant that an LLC that had limited liability also had to be sure that it had no more than one of the other "corporate" characteristics of free transferability, continuity of life, and centralized management.

LLCs also posed uncertainties that tax rules could not solve. LLCs began as basically the offspring of partnerships and limited partnerships, with the addition of full-fledged limited liability. But how would courts treat this hybrid?

Clarification would come as more LLCs were formed, but who would form LLCs until important issues were clarified? For want of an egg, the chicken was lost. One way to provide clarity for LLCs would be to borrow the partnership “network” of cases and forms by tacking limited liability onto the existing partnership form. In 1991, Texas developed the limited liability partnership (LLP) to ease law firms' transition to limited liability in the wake of the savings and loans crisis of the late 1980s and early 1990s. The LLP form let partnerships get limited liability while otherwise being treated as partnerships. Yet as theoretically attractive as this approach might be, in fact LLPs have remained a niche form, used almost exclusively by professional firms.

The LLC form, however, marched on. By 1996, every U.S. jurisdiction had an LLC statute. NCCUSL finally promulgated its Uniform Limited Liability Company Act. Since every statute allowed for foreign LLCs, LLCs clearly could do business nationwide. The IRS, forced to deal with ever more complications under the classification rules, and facing universal acceptance of the LLC *13 form, finally gave up trying to put business entities in tax boxes. Under Treasury Regulation 301.7701-1 -3, effective Jan. 1, 1997, firms could decide for themselves -- that is, "check the box" -- whether they wanted to be taxed as partnerships and corporations.

The check-the-box rule took the lid off of the growth of LLCs. Tax returns for the year 2000 report 718,704 domestic LLCs, up from 589,403 in 1999. The 2002 Annual Report of the Jurisdictions of the International Association of Corporation Administrators shows 521,953 domestic and foreign LLCs filing in 43 reporting states for 2001, compared to 474,791 for 2000.

LLCs' spread solved the "chicken-egg" problem with the development of LLC law by establishing a sizable constituency of lawyers and business people who support and provide clarification and refinement. Courts are deciding LLC cases at a rate comparable to or exceeding partnership cases.

State legislatures and bar committees also have adapted LLC statutes to meet current business needs. For example, the vast majority of LLC statutes eliminated the partnership rule permitting members to dissolve or exit at will. State statutes also have evolved toward substantial uniformity with respect to many types of provisions, thereby facilitating nationwide practice even without an official uniform law.

LLCs' growth demonstrates both the folly of trying to predict the future and the need to preserve flexibility. Just as the LLC seems to be taking over from the close corporation and limited partnership forms, changing business conditions might cause the LLC to be replaced by some new or hybrid form.

 

Copr. (C) 2004 West, a Thomson business. No claim to orig. U.S. govt. works. This article is reprinted with permission from West, a primary sponsor of the General Practice, Solo and Small Firm Division.

 

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