Last week we discussed the history of the limited liability partnership. As mentioned, in the next several weeks, This Week in Real Estate will examine Limited Liability Partnerships (LLP) and Limited Liability Companies (LLC).; their history and similarities and differences. This week we will discuss the history of the limited liability company (LLC).
The history of the LLC may be summarized as follows:
In 1977, Wyoming enacted the first LLC statute, and in 1982, Florida enacted the second. These statutes were based in part on a European civil law model. Their intent was to simultaneously provide both liability shields and federal partnership tax to all owners. At that time, there was a dilemma or a disconnect between liability shielding of ownership and tax liability. While corporations provided liability shields for all of their shareholders, it could not qualify for partnership tax, but was required to file its taxes as a corporation. For many multi-owner businesses, the corporation tax regimen is inferior to partnership filing, for example, because of “double tax” (which may be the subject of a later edition of This Week in Real Estate). Conversely, general and limited partnerships could provide partnership taxation, but general partnerships provided no liability shield to their partners, and limited partnerships provided them only to limited partners, not to general partners.
Until 1989 there were serious federal income tax questions about LLCs, so very few of them were formed. On September 2, 1988, the Internal Revenue Service released Revenue Ruling 88-76. This IRS administrative ruling held that multi-member LLCs, if properly structured, could qualify for federal income tax partnership classification under Subchapter K of the Internal Revenue Code even though all of their members had statutory liability shields. Therefore, Revenue Ruling 88-76 resolved the most important unanswered question about the federal income taxation of LLCs, and it caused, beginning in 1990, a historically unprecedented legislative charge among the states to enact LLC statutes.
By 1996, all 50 states and the District of Columbia had enacted statutes authorizing the formation of multi-member LLCs. This meant that, by 1996, the members of multi-member LLCs could be assured of limited liability in all U.S. jurisdictions.
On January 1, 1997, the “check-the-box” regulations became effective. These regulations not only made it easy for multi-member LLCs to qualify for partnership taxation but also for single-member LLCs to qualify for often highly favorable “disregarded entity” federal income tax treatment. As disregarded entities, single-member LLCs themselves would be ignored for federal tax purposes, and their federal tax items would be treated as those of their members. In addition, the “check-the-box” regulations enabled both single-member and multi-member LLCs to elect into Subchapter C and, if they met eligibility and election requirements, into Subchapter S.
The “check-the-box” regulations made it possible for the first time in U.S. business law history for individuals to obtain, among other single-member LLC benefits, statutory liability shields without the need to deal with the statutory formalities of the corporate business organization form and with the resulting veil-piercing issues. And it enabled entities to form subsidiaries that would provide these entities with liability shields without any need to comply with corporate formalities or with the complexities of the Internal Revenue Code consolidated return rules. The issuance of the “check-the-box” regulations was the single most important historical factor enabling LLCs to become the entities of choice for U.S. business start-ups, and they triggered a significant increase in the rate of U.S. LLC formations that has continued to this day.
Note: on January 13, 1997, just 12 days after the issuance of the “check-the-box” regulations, the Internal Revenue Service issued a proposed regulation, designated Prop. Reg. § 1.1402(a)-2 (the “Prop. Reg.”). The Prop. Reg. applies to multi-member LLCs taxable as partnerships. It provides guidelines to individuals who are members of these LLCs on how to avoid the Self-Employment Tax on their shares of LLC income. The Prop. Reg. is not widely known among tax practitioners. However, the IRS has publicly and repeatedly stated that it is its audit guideline on LLC SET issues, and it provides members of multi-member LLCs taxable as partnerships with a powerful tool for lawful Social Security Tax and Medicare tax avoidance.
In 2003, Massachusetts became the 51st U.S. jurisdiction to authorize single-member LLCs. It thus ensured the members of single-member LLCs, like those of multi-member LLCs, that they would have limited liability in all of these jurisdictions.
Next week, This Week in Real Estate will discuss the characteristics of the limited liability partnership.
Disclaimer: This material has been prepared for informational purposes only, and any tax advice contained herein was not intended or written to be used, and cannot be used, for the purpose of avoiding tax-related penalties or promoting, marketing, or recommending to another party any tax-related matter addressed herein.
ABOUT JAMES LANDON
Jim Landon has practiced real estate law since 2002 and has been involved in real estate investment and construction for most of his life. Jim’s practice focuses on real estate transactions and land use.
Jim represents individuals and privately and publicly held companies in the purchase, sale, leasing, financing, and development of real property. He also represents title insurance companies on commercial purchases and refinancing transactions, as well as providing third-party legal opinions regarding Delaware law related to Delaware entities.
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