The LLC (Limited Liability Company) Origin
In the late 1970s, the Wyoming legislature introduced a little-known business entity that would revolutionize the way America does business.
Overview
In 1977, the Limited Liability Company (LLC) was born in Wyoming. Today, the entity is by far the most popular choice for new businesses, holding companies, and all types of business ventures, but the LLC’s arrival was to little or no applause. Even though the LLC is used far more by new enterprises than the corporation, it took more than 20 years for the LLC to be seen as a viable option. Below, we’ll explore why the LLC’s origins, its struggle to become accepted, and how the LLC has flourished.
Background
In the beginning, there was only the corporation. It was the only business entity option that afforded business owners direct statutory limited liability. But the corporation wasn’t a perfect vehicle for doing business. By default the corporation is taxed as a C-corp, which is known for its double taxation. The corporate profits are taxed by a corporate tax, then when the profits are distributed to the shareholders, that income is taxed again as personal income. While the C-corp structure does offer some investment strategies for large companies, the double taxation charge was unavoidable for any business owner who wanted the protection of limited liability. There were some businesses that could qualify and register as S-corporations and avoid the double taxation, but that was far from the majority. This lack of diversity in taxation left a space of need open in the business world, and the Wyoming legislature noticed and filled that void with the Limited Liability Company (LLC), which utilized the asset protections of the corporations with the taxation principles of the partnership.
The Birth of the LLC
The introduction and rise of the LLC is actually a story about the conflict between the IRS and the needs of business owners. The first LLC was formed in Wyoming, but like most things, it was not the government’s invention. The first LLC Act, established March 4, 1977, was the manifestation of well-thought out plans designed by a several accountants and lawyers working for an the Hamilton Brothers Oil Company.
The Hamilton Brothers Oil Company was based in Denver, CO, and it had been doing business overseas as various types of entities established abroad that afforded the company both pass-through taxation (the way partnerships are taxed) and limited liability protections. However, the Hamilton Brothers Oil Company was afraid that the limited liability protections wouldn’t be recognized in the US. One of their options would have been to form a limited partnership, where the limited partners are protected by limited liability protections. The general partners in an LP, however, do not have these protections, but there was already an established record of LPs using a corporation as the general partner. This could have potentially worked for the Hamilton Brothers, but their attorneys and accountants pushed the company in a different direction.
Although, the first LLC was formed in Wyoming, it was almost formed in Alaska. The attorneys working for Hamilton Brothers first drafted and brought proposed legislation to Alaska. They thought the LLC would be a big hit with other oil companies and that the Alaska legislature would allow the creation these entities without much hassle. But they were wrong. Although the proposed LLC statutes were discussed at length in Alaska, the act was brought up to vote twice, in 1975 and in 1976, and failed both times. Instead of waiting for a third vote, the exact same legislation was brought to Wyoming and passed without hesitation.
Battle with the IRS
Although the first LLC was formed in Wyoming in 1977, there was no rush to organize a company as one. This is largely due to a lack of a ruling from the IRS as to how LLCs would be taxed federally. Initially, the IRS issued a notice that they needed two years to study the effects such an entity would have on tax laws. And the first IRS ruling in 1980, was not heartening. It stated any entity that provided limited liability protections would be taxed as a corporation. Attorneys in far away places like New York went bananas. Their concern wasn’t for the LLC, it was for entities like trusts which would be affected by the new IRS rules. These high-powered law firms railed against the IRS, which eventually withdrew the proposed regulations. However, it wasn’t until September 2, 1988 that the IRS finally issued a ruling that LLC would be taxed as a partnership and afford limited liability protections to LLC members.
Sadly, during the decade the IRS took deciding on LLCs should be taxed federally, the Hamilton Brothers Oil Company was never able to register as an LLC. Prior to 1988, there were only a handful of LLCs formed and only Florida followed in Wyoming’s footsteps and introduced LLC legislation.
The Popularization of the LLC
After the IRS issued their rulings in 1988, other states started to slowly introduce LLC provisions to business owners in their states. But there was still one major problem with the LLC. When Wyoming introduced LLC legislation, their LLC Act has basically written into law what we now know a Wyoming Close LLC. The first LLC limited the members’ abilities to transfer assets and for the company to exist in perpetuity—no matter what the LLC’s operating agreement stated. Attorneys across the country realized that in order for the LLC to be truly useful, these restrictions needed to change, but they knew it may also alter how the LLC was treated by the IRS.
Two attorneys, Barbara Spudis and Bob Keatinge, spearheaded the effort. For two years, a group of 10 volunteers met every Saturday to draft an LLC Act prototype that could be used by all states. But no one wanted to have the entity put back into IRS limbo. So as members of an American Bar Association taxation subcommittee, Spudis and Keatinge met often with IRS attorneys to establish a way forward. This resulted in a mass amount of bureaucracy and strategic maneuvering. It also required the states to push forward with legislation to force the IRS’ hand. More than half the states had passed LLC provisions before the IRS finally relented and issued a ruling in 1994 that affirmed the work Spudis, Keatinge and many volunteers had done to allow the formation of LLCs.
In 1996, after the last three states finally passed LLC legislation, the IRS issued its final ruling, the ones we still use today.