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Brief History of the LLC

Have you been wondering: Should I form a corporation or an LLC? Here at San Diego Corporate Law, we can help you decide which type of entity will best meet your needs, and for many people means forming California limited liability companies (“LLC”). A brief history of the LLC helps explain why an LLC is often a good choice when forming your San Diego business entity.

Wyoming was the First State

Wyoming was the first state to pass legislation allowing LLCs in 1977 with the impetus coming from the oil and gas exploration industry. See Professor Susan Pace Hamill’s excellent scholarly article here.

The main issues were taxation, asset protection, and limitations placed on “S” corporations by the IRS. Prior to the LLC, businesses had two general options: general partnership and a corporation. In partnerships, there is equal sharing ownership, control, profits and losses, and the very important tax advantage that any profits are taxed once as personal income of the partners. Partnerships are “pass through” entities for tax purposes.

On the downside, individual partner assets were at risk if there were losses, and the personal assets of one partner could be used by creditors to pay the debts and obligations of the partnership. The partnership also did not have “continuity of existence” since the partnership was dissolved upon the exit of any one partner and, correspondingly, every partner could dissolve the partnership by exiting. The nature of a partnership effectively limited the size of the business.

As one can imagine, a partnership was not ideal for the oil and gas exploration industry.

By contrast, corporations, as a business form, had the advantage of shielding personal assets and the corporation had “continuity of existence” since shareholders cannot unilaterally dissolve the corporation. Corporations also had/have no limits on how many shareholders are allowed. On the downside, corporation are taxable entities — the so-called “double taxation” problem. The regular corporation was ideal for large business; but not so ideal for the oil and gas exploration industry.

In the 1950s, the IRS allowed for the existence of the sub-chapter “S” corporation which treated corporations as corporations in all respects but allowed pass-through of the profits under certain circumstances. There were severe limits on the number of shareholders and only individuals could become business owners. Again, the “S” corporation had some advantages over “C” corporations and both had advantages over partnerships, but none were ideal for the oil and gas exploration industry. What was wanted was the flexibility and tax treatment of the partnership form coupled with the corporate asset shield provided by the corporate form.

From this need was born the Limited Liability Company.

Subsequent History

It took a few years for the IRS to approve the “pass-through” aspect of the Wyoming LLC. Under the IRS regulations, the test for whether a business form was a “corporation” for taxing purposes was the four-characteristics test: free transferability, continuity of life, centralized management, and limited liability. If two characteristics were missing, then the business organization would be taxed as a partnership. In 1988, the IRS issued Revenue Ruling 88-76, stating that Wyoming LLCs would be taxed as partnerships despite possessing the corporate characteristic of limited liability. After 1988, the states began enacting LLC laws. California allowed LLCs in 1996 with the enactment of the Beverly-Killea Limited Liability Company Act. That law was substantially amended in 2014.

Contact San Diego Corporate Law

For further information, please contact Michael Leonard, Esq. of San Diego Corporate Law. Mr. Leonard has the experience to help you create your LLC (or corporation), keep it in good standing, can create and review your operating agreement, and assist with any business-related legal matter. Contact Mr. Leonard by email or by calling (858) 483-9200.

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Schedule a Consultation: 858.483.9200