The Limited Liability Comany (LLC) is one of the most popular legal forms in the United States. Even Google has recently switched the legal form from a corporation to an LLC. We explain why the LLC is so popular, how it came to be and the reasons for it.

Originally there were only two forms of company in the USA: the general partnership, which did not require state approval, and the corporation, which was only created by a state act. Then two other forms of organization were added: the business trust and the limited partnership. However, only with the introduction of the LLC was an attractive new mixed form available in the United States. It combines the elements of the two traditional models of partnership and corporation. In addition, the limited liability partnership and the limited liability limited partnership were developed.

Reason for the introduction of the LLC were essentially tax motives. In the United States, corporation tax was introduced by the Income Tax Act of 1913. According to the law, it applied and applies to the corporation, joint-stock company or association [...] no matter how created or organized, not including partnerships. For partnerships, it therefore remained a transparent taxation.

The dividing line to the corporation has been drawn by the Internal Revenue Service (IRS), the US tax authority, according to four criteria since 1960. Subsequently, for the classification as a corporation tax subject, the unlimited life of the company, the centralized management, the limitation of liability and the free transferability of the company shares were decisive. If at least three criteria were met, the company concerned was subject to corporate tax.

The right to exist and the success of the newly created LLC, on the other hand, depended on the fact that it had to be classified by the tax authority not as an association, but as a partnership. Its corporate law was therefore shaped from the outset in the shadow of the tax law framework conditions.

The decisive impetus for the creation of the LLC came from the Hamilton Brothers Oil Company. It was organized in foreign legal forms, in particular in the Panamanian sociedad de responsabilidad limitada. This combined the corporate liability restriction with the classification as a partnership under US tax law. However, there were difficulties for the Hamilton Brothers Oil Company because the guaranteed capital could not exceed USD 500,000 and because only natural persons could act as shareholders. In addition, the US courts did not accept the limitation of liability without exception. The company therefore commissioned a consultant who was to convince a national legislature to develop a form of company that provided for limited liability with transparent taxation. The components were equally important because of the company’s risky and speculative business.

The consultant drafted a draft regulation for the LLC and submitted it to the Alaska legislature in April 1975. But he was not pursued there, probably because the legislature expired. Shortly thereafter, he wore an identical bill according to Wyoming. There he was accepted and resigned on the 4. March 1977 in force.

In terms of tax law, the LLC has not yet been recognized by the IRS. Only more than three years later – in November 1980 the LLC was incorporated. At the same time, however, the IRS published a proposal that all limited liability companies should automatically be treated as corporations in the tax sense, so that the LLC should also be considered a corporation. However, since this proposal was received with considerable indignation, the IRS withdrew it and announced a comprehensive audit. It lasted five years. Meanwhile, the tax status of Wyoming LLC remained in limbo. Therefore, the interest in the establishment of the LLC was lost. Until 1988, there were only 26 registered LLCs in Wyoming.

Against this background, the LLC did not spread to the other states for the time being. Only five years later, a separate LLC statute was introduced in Florida. However, the direction was different. They wanted to attract investors from Central America and South America. Therefore, an organizational form was chosen that resembled the limitada known there. However, the hoped-for flood of applications did not occur. A year after its entry into force, only two LLCs were registered in Florida.

The classification of the LLC as a partnership proved problematic. In September 1988, the IRS stated that the LLC’s limitation of liability did not preclude its classification as a partnership. Rather, it would depend on the above four criteria in their entirety. All of them are considered equal. In response, the legislature in Wyoming changed its LLC Act. He introduced resolution provisions and transfer provisions as mandatory requirements to minimize tax risks for LLC founders. As a result, however, the LLC lost its attractiveness and was henceforth only considered for small closed-ended associations.

In the following years, numerous open individual questions about the taxation of the LLC were discussed in the dialogue between the IRS and the legal profession. However, a final solution did not exist until early 1997, after all states had their own LLC Act. The IRS abolished all tax classification rules for partnerships and replaced them by the new regulation of the so-called check-the-box regulations. According to this, the shareholders of a non-incorporated company, irrespective of their specific configuration, can select taxation according to partnership law or corporate law principles. Therefore, the taxation of the LLC now depends on the will of the shareholders. This is precisely what makes the LLC so attractive for entrepreneurs. For the LLC with at least two shareholders, transparent taxation forms the legal basis. Corresponding models now exist in German tax law, so-called option taxation (§ 1a (1) sentence 2 KStG). However, these are far from being as well developed as in the USA.

After its insertion, the above-mentioned bullet-proof statutes proved to be superfluous. Therefore, the States concerned amended their laws in order to give LLC founders greater freedom of design with regard to the life of the company and the transferability of the shares.

In 1996 there was also the possibility of establishing the LLC in the last state. Almost everywhere, the adjustment served the purpose of attracting new companies and not falling behind other states that already had appropriate regulations.

This resulted in a real founding boom, which quickly brought the number of LLC to several 10,000. In 2003, according to IRS income tax statistics, the million mark was reached, seven years later the mark of two million. The latest available tax data from 2018 shows around 2.8 million LLCs. The LLC has thus clearly left the traditional legal form of partnership and limited partnership behind. It is only surpassed by the more than six million corporations and 27 million individual companies (sole proprietorship).

The laws of the individual states on the LLC vary greatly. Therefore, in individual cases, it is necessary to check how the LLC is designed exactly. Nevertheless, there are basic structures that can be found in every state. This includes the legal form. The LLC is usually a hybrid form of corporation that has elements of both partnership and corporation. This intermediate position is also reflected in the designation as a company. This is not assigned to any particular legal form in the USA. A neutral term has also been found for its members. They are not called partners or shareholders, but members.

The LLC has its own legal personality. It can therefore itself acquire rights and enter into liabilities, as well as sue and be sued in court. Unlike partnership, it can only consist of one person in most states. It is even planned to create a memberless shelf LLC, with the proviso that one or more members must be nominated within 90 days. Their social purpose can be economically or ideally oriented. A nonprofit LLC is also allowed. A partnership, on the other hand, must always pursue an economic purpose.

In economic life, the LLC is mainly used by small and medium-sized companies with a closed circle of shareholders. However, it does not focus on a particular industry or economic sector.

In addition, the LLC is used as a hedging instrument for real estate financing or for professional sports leagues and large multinational companies. In a manageable number, LLCs are even traded on the US stock exchanges.

In order to establish the LLC, the founders must submit a document of incorporation to the competent authority. Details of the governance structure are usually set out in a separate document, but are not publicly available. This agreement regularly constitutes the key document. It can be tailored entirely to the specifics of the LLC in question and then replaces the compliant provisions of statutory law. The organizational structure can be adapted to a large extent. Most states provide for management by the shareholders as a statutory regulation. Then the LLC resembles a partnership. A few states, on the other hand, assume the basic model of management by the external managing director, so-called manager-managed LLC. Then the central management structure resembles that of a corporation. Mixed models are also possible.

The shareholders cannot be called upon by the company creditors. Liabilities of an LLC are therefore solely these. Of great practical importance is the subsequent question of whether adhesion penetration is possible under certain conditions. Some states have expressly stipulated that they declare the traditional case-law applicable accordingly. Others restrictively state that a failure to comply with formalities in itself does not provide any grounds for a breach of liability. In most states, however, the shareholders can clarify the liability crackdown. In a decision of principle, the Supreme Court of Wyoming accepted in principle the possibility of interference liability.

Some states provide for voting rights by head parts, others by share of capital. Such differences are also found in the design of the right of profit. Each shareholder can transfer his membership interest. In this case, however, the acquirer can only assert the property rights from the share. However, he will only become a shareholder if the co-shareholders agree. Most LLC laws require a unanimous shareholder resolution. However, they allow for majority clauses in the operating agreement.

If you look at the history of the creation of the LLC, the decisive impulses for development come from corporate practice. In order to solve the limitations of corporate law, a method was sought to combine limited shareholder liability with transparent taxation according to principles of corporate law. The introduction had mainly tax reasons, which lie in the transparent taxation. In addition, there is the limitation of liability of the shareholders, which also applies if the shareholders influence the management. This benefited the oil industry in particular at that time. Many of them financed the costly test drilling by selling partnership shares to high net worth investors under tax loss allocation models. With the introduction of the LLC, this was no longer necessary.