The rise and rise of the LLC

US INCORPORATION TRENDS: Part 2

Article by Ana Muñoz Padrós & the OpenCorporates Insight Team

Wyoming’s spectacular rise to overtake Delaware in per-capita company incorporations has been powered by what has fast become the dominant legal form in the US, the LLC, a form of limited partnership.

In our last post we showed how company incorporations in Wyoming have exploded in the past 5 years, growing 42 per cent in the past year alone, powered by a huge increase in LLC incorporation. This is both part of a wider trend, and also its own distinctive story.

Let’s first look at what an LLC is, especially for non-Americans (see this scholarly paper for a full history).

The LLC, or Limited Liability Company, was born in Wyoming, as it happens, in 1977. Like many aspects of legal entity structures, the drivers were basically tax and liability. It had been crafted on behalf of an oil company, based in Denver, Colorado, Hamilton Brothers Oil Company, which wanted a legal form that would be taxed as a partnership, but would enjoy the legal personality and limited liability of a corporation (essentially the same form as the Panamanian Limitadas, which they had been using, but carried risks, as it wasn’t clear that US courts would respect the limited liability).

The oil company’s representatives first went to Alaska, and when that failed, they approached Wyoming – both having easily approachable legislatures – and less than a year later the “Wyoming Limited Liability Company Act” was passed. The critical aspect here is that creating a new type of legal entity that could do business across the whole of the US does not require either Federal approval or approval of the states where it will be doing business – it just needs one state to allow its formation.

However, it *is* the Federal government, specifically the IRS, that determines Federal tax, and although the Wyoming law was crafted so that it would on face value qualify as a partnership, years of wrangling ensued between the proproponents of the LLC, and the IRS. Clarity emerged bit by bit, and in 1988 the IRS issued Revenue Ruling 88-76, which basically allowed LLCs to elect to be taxed either as corporations or as partnerships. The latter, broadly, allows for the income to be taxable only when it flows through to the partners, or members as they are known in the LLC world (hence the description of LLCs as ‘flow-through entities’).

This ruling, however, didn’t open the floodgates. In fact, in the next few years, only a handful of states enacted LLC legislation, and in 1991, for example, fewer than 2,000 LLCs were formed between them.

Registrations of new LLCs in the US (including DC). The blue line represents the total number of LLCs incorporated in the US per year.

Incorporations of Limited Liability Companies have tripled in the US over the last decade.

The challenge was that in order to be treated like a partnership for tax purposes, it needed to look like a partnership, prohibiting things like automatic continuation of life when a member died or left, easy transferability of interests and single-member LLCs, and whether management was decentralised or not. But over a three-year period from 1992-1994, everything changed, with 40 states enacting LLC laws, and the IRS agreeing to virtually all of the requests.

The result was a legal entity form that provided owners with the best of both worlds: it gave them the benefits of a partnership for taxation purposes (broadly, the profits would belong to the members, and declared on their tax returns, rather than the entity being taxed); at the same time, it was a separate legal entity, and one with limited liability, so that the members were not personally liable for the losses of the entity, just like a corporation. It also, as a ‘partnership’, meant that it was treated in many states more like a contractual agreement, with limited governance requirements or transparency for those doing business with it.

In the next two decades, powered by this best-of-both-worlds legal treatment, the LLC became popular not just in Wyoming but across the country, and not just for small businesses but for a wide range of purposes – for example, the main division of Alphabet Inc., the holding company of Google, is not Google Corp, but Google LLC. But in the past 10 years, this has exploded, with millions of incorporations a year, and LLCs significantly outnumbering any other legal form.

Registrations of new entities in the US (including DC) and proportion of company types. Blue sections represent LLCs and golden sections other types of entities.

The proportion of new Limited Liability Companies has increased by 12 percentage points over the past decade. Download the data here.

Of course, a reasonable question to ask is: what are the implications of this? Is there now any meaningful difference between a Corporation and an LLC, aside from the opacity, lack of governance requirements and the uncertainty of the legal frameworks that generally come with the latter – which, in turn, makes it harder to assess the risk of doing business with them.

And this still doesn’t account for how and why Wyoming’s growth in incorporations grew exponentially in the past 10 years, and has now, on a per capita basis, eclipsed every other state, including Delaware. We’ll be discussing that in the next post in this series.

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