As most business owners and business lawyers know, the limited liability company (LLC) is by far the most popular form of statutory business entity in the United States. And it achieved that distinction rather quickly. The first LLC statute was not enacted in the United States until 1977. Furthermore, 40 of the 51 jurisdictions passed their first LLC statutes between the years 1992 and 1997. Consequently, the LLC has really existed as a significant business entity in this country for only around 30 years.
LLC law has gone through a great deal of change during those 30 years. The LLC statutes we see today are different in many ways from the LLC statutes of the 1990s. Different, as well, is the body of case law, which is much larger and exhibits a much greater understanding of the unique needs of the LLC and its owners than seen in the past.
In this white paper, we will take a look at the current state of LLC law and will discuss how and why LLC law has evolved into its current state. This is a discussion that should be of interest to anyone who owns or manages an LLC, or plans on owning or managing an LLC, or who provides professional advice to LLC owners and managers.
B. What is an LLC? A few basics
An LLC is a statutory business entity that is formed by the filing of a document with the business entity filing office of one state. This document contains certain basic information about the company. The owners of an LLC are called members. An LLC may be managed by all, none, or some of its members.
The basic governing document of an LLC is a contract entered into by the members called an operating agreement. It is the operating agreement, and not the formation document or LLC statute, that typically governs the regulation of the affairs of the LLC, the conduct of its business, and the relations among its members, between its members and the LLC, and between its members and managers.
An LLC exists as an entity separate and apart from its owners. Parties doing business with an LLC must look to the company to satisfy any obligations owed to them. The members of an LLC have limited liability.
The governing LLC statutes consist mainly of default provisions. The members can opt out of these statutory provisions in their operating agreement. The statutes have few mandatory provisions other than requiring certain filings to be made and requiring the maintenance of an agent for service of process.
C. Five key features of the LLC
Certain features of the LLC have significantly influenced the LLC statutes and case law. They include the following:
1. An LLC is a hybrid entity
An LLC combines the features of a corporation and a partnership. In enacting and amending their LLC statutes, the legislatures were influenced by their states’ corporation, limited partnership (LP), and general partnership (GP) laws. In addition, the courts, in interpreting provisions of the LLC statutes, have looked to the comparable provisions of the statutes governing corporations and partnerships.
Furthermore, in deciding cases involving an LLC’s internal affairs or the relations among LLC members, the courts have looked to previous decisions involving corporations and partnerships as a starting point for their analysis.
2. An LLC is, in most cases, a closely held entity
The vast majority of LLCs are closely held. A closely held entity is an entity (1) where the ownership interests are not publicly traded and where there is no established market for those interests, (2) where there are relatively few owners, and (3) where the owners usually manage the business together and are often key employees as well.
The problems and concerns of closely held entities and their owners are different from those of publicly traded entities and large, widely held private entities. Most legislatures and courts recognize this difference. Thus, it impacts both the LLC acts and court rulings.
3. An LLC is, in most cases, a “pick your partner” entity
When the owners of a business are also the managers, it is considered important that they have the ability to choose who their fellow owners will be. It is particularly important when the business is their main source of income or represents a substantial investment. The legislatures and courts are aware of the importance of members being able to “pick their partner”, which influences both LLC statutes and judicial decisions.
4. An LLC is a contractual entity
An LLC is more of a contractual entity than a statutory entity. The legislatures anticipate that the members will provide for the governance of the LLC and for their own rights, duties, and obligations in their operating agreement. This results in statutes with mainly default provisions governing many areas and no provisions at all governing others. It also results in court decisions applying contract law principles to decide many LLC cases.
5. An LLC is a flexible entity
The LLC was created, in part, because businesspeople wanted an entity with the flexibility of a partnership but with the limited liability of a corporation. The desire to provide businesspeople with flexibility has resulted in statutes with few restrictions on how the members can manage the LLC or allocate their financial rights.
D. Four events that influenced LLC law
In order to understand today’s LLC law, it is necessary to understand certain events in LLC history. The following four events, in particular, have significantly influenced the development of LLC law.
1. Hamilton Brothers Oil Company lobbies for the enactment of an LLC law
Hamilton Brothers Oil Co. was involved in international oil and gas exploration. The company used LLCs created in foreign countries. Mainly, it used a Panamanian entity called the limitada. Unlike the American entities available at that time, limitadas offered limited liability and partnership taxation. For various reasons, Hamilton Brothers Oil Co. found that it could no longer use these foreign entities. It decided to have legislation drafted creating a domestic unincorporated entity that would provide limited liability and partnership taxation.
In 1975, Hamilton Brothers’ representatives presented its LLC legislation to the Alaska legislature. The bill died. An identical LLC bill was then presented to Wyoming’s legislature. It passed with little struggle and went into effect in 1977.
2. Revenue ruling 88-76 is issued; Kintner rules are applied
The LLC was intended to offer partnership taxation. But, for eleven years after Wyoming passed the first LLC act, the IRS failed to state how it would classify the LLC.
Finally, in 1988, the IRS issued a ruling stating that a Wyoming LLC would be taxed as a partnership. This was Revenue Ruling 88-76.
In Revenue Ruling 88-76, the IRS applied the Kintner entity classification rules to determine whether the LLC should be taxed as a corporation or a partnership. The Kintner rules identified four corporate characteristics: limited liability, centralized management, free transferability of interests, and continuity of life. Any unincorporated organization lacking two of the four characteristics was taxed as a partnership. An organization with at least three of the characteristics was taxed as a corporation.
The Wyoming LLC in Revenue Ruling 88-76 was characterized as a partnership because it lacked two of the four corporate characteristics. It lacked continuity of life because the withdrawal of a member caused dissolution unless all members voted to continue the business. It also lacked free transferability of interests because all members had to approve before a transferee could become a new member.
After this revenue ruling, the states rapidly began adopting LLC acts. During the next six years, 45 states enacted LLC laws. This is compared to just two states that passed LLC laws in the 11 years before the ruling.
3. Colorado adopts a “flexible” LLC act
In 1990, Colorado became the first state to adopt a “flexible” LLC act. The previous LLC statutes had been what are called “bulletproof” acts. Bulletproof acts were intended to ensure partnership taxation. For example, they required unanimous consent to admit new members and to continue the business after an event of dissolution. This was to guarantee that the LLC would lack the corporate characteristics of free transferability of interests and continuity of life.
Under a flexible statute, on the other hand, the LLC had the option of requiring less than unanimous consent, by so providing in its operating agreement. The flexible statutes allowed the members to better tailor the LLC to meet their individual needs. As a result, the LLC became a more attractive entity choice.
4. “Check-the-box” rule is enacted
Revenue Ruling 88-76 made it clear that an LLC could be taxable as a partnership. Nevertheless, the Kintner test still left a great deal of uncertainty.
For example, it was not clear whether an LLC would lack the characteristic of continuity of life if it required a majority vote, rather than a unanimous vote, to continue after dissolution. Nor was it clear how a single-member LLC would be taxed. In 1997, these questions were answered when the Treasury Department’s “check-the-box” rule went into effect.
The check-the-box rule radically changed how LLCs would be classified for federal income tax purposes. The Kintner test was abandoned. Instead, an LLC with two or more members would, by default, be treated as a partnership. Single-member LLCs would, by default, be disregarded as an entity. LLCs also had the option of electing to be taxed as a corporation
The check-the-box rule, by clarifying the LLC’s tax status, spurred the formation of many LLCs. It also caused many states to amend their laws to repeal restrictive provisions that were intended to assist LLCs in being characterized as partnerships for tax purposes.
E. Three generations of LLC statutes
There are said to be three generations of LLC statutes. The first generation was the bulletproof LLC statute containing unalterable provisions designed to ensure partnership taxation.
The second generation was the flexible LLC statute with mainly default provisions. The current LLC statute is the third generation. It represents the first- and second-generation statutes amended for various reasons, including those discussed below.
F. Five reasons for amendments to LLC statutes
The state LLC statutes have been significantly amended since they were first enacted in the 1980s and 1990s. The impetus for the changes made to the LLC statutes includes the following.
1. The check-the-box rule
This rule made it unnecessary to have statutory provisions designed solely to avoid corporate taxation. It allowed the states to amend provisions governing such matters as dissolution, the period of duration, the number of members, and the transferability of interests.
2. The need to fill in gaps
As time passed after the LLC statutes were originally enacted, it became apparent where the LLC statutes failed to address issues that needed to be addressed. Amendments were enacted to fill in those gaps.
3. The need to clarify provisions
The passage of time also revealed that certain provisions of the LLC statutes that seemed clear when drafted were not so clear when they actually had to be relied on by the LLC’s principals or legal advisers. The need to clarify ambiguous provisions resulted in amendments being made to the LLC statutes.
4. Legislative anticipation vs. realities
In enacting the original version of the LLC statutes, the legislatures tried to anticipate how LLCs would be used and what the needs would be of the LLCs, their members, and managers. Where the statutes proved inadequate to meet those actual needs, amendments were made.
5. Reactions to court decisions
Sometimes the courts will interpret an LLC statute in a manner not intended by the legislature. Or a court case can reveal an ambiguity that the legislature did not realize existed. The legislatures may react to these cases by amending the LLC law.
G. The current state of LLC law
Below is a brief discussion of what the current version of the LLC statutes typically provides in certain key areas. It also discusses how and why the provisions governing these issues have changed over the years.
1. Formation document
The current LLC statutes provide that the formation of an LLC requires the delivery of a document with the state business entity filing office. This document is generally called the Articles of Organization.
The main function of this document is to provide the public with notice that a limited liability entity has been formed. It is not intended to provide information on the entity’s financial structure or the rights and responsibilities of its managers or owners. As such, the statutes generally require the formation document to set forth little more than the LLC’s name, principal office address, and the name and address of its agent for service of process. Several states also require a statement as to whether the LLC will be managed by members or managers.
The earlier statutes required more information to be set forth. For example, they required a statement regarding the latest date the LLC could dissolve. This was to assist the LLC in avoiding the corporate characteristic of continuity of life.
However, after the check-the-box rule, it was no longer necessary to do so.
The LLC statutes today contain few restrictions on an LLC’s purposes. An LLC may be a for-profit entity or a not-for-profit entity. It may also practice a profession. Earlier statutes did not specifically provide for non-profit LLCs. Some did not allow an LLC to practice a profession. In addition, many of the original LLC statutes did not permit LLCs to engage in the businesses of insurance or banking. (Some still have this restriction.)
3. Operating agreements
The statutes today, like the statutes in the past, provide for member operating agreements. Early statutes required these agreements to be in writing. Most statutes today say they can be in writing (or a “record”), oral, or implied. (Implied meaning the default provisions of the statute will apply.)
In recognition that the LLC is a contractual entity, the statutes impose few restrictions on what the members may set forth in their operating agreement in regard to how the LLC will be run and to the members’ rights, duties, liabilities, and responsibilities. And in fact, amendments made to the original provisions dealing with operating agreements have tended to expand what the members may provide therein, rather than to impose restrictions. For example, several states amended their laws to provide that fiduciary duties may be eliminated in the operating agreement.
4. Number of members
The current statutes provide that an LLC may have one or more members. Under the original laws at least two members were required. This was because the legislatures anticipated that an LLC with only one member would be taxed like a corporation.
The statutory amendments that permitted the formation of single-member LLCs were important events in LLC history. They greatly increased the usefulness of the LLC as an entity.
5. Membership interest
A membership interest consists of financial rights and non-financial rights. The chief financial rights are the right to share in allocations of the company’s profits and losses and the right to share in distributions of the LLC’s assets during its existence and when it dissolves. The non-financial rights (sometimes called management or governance rights) include the right to vote, to inspect books and records, and to bring a derivative suit.
The LLC statutes contain default rules for allocating the members’ financial and voting rights. Some statutes give each member equal rights to vote and share in profits, losses, and distributions. Others apportion voting and financial rights based on the amount of the investment. In some states, these default rules have not changed from the earlier versions of the LLC statutes. In others, they have.
6. Transferability of interests
The current LLC acts provide that the members may sell, assign or transfer their membership interest in whole or in part.
However, unless the operating agreement provides otherwise, all the buyer, assignee, or transferee receives is the member’s financial rights. The buyer, assignee, or transferee does not become a member or receive any management rights.
The LLC statutes as originally enacted also restricted the members’ ability to sell, assign, or transfer their management rights. These provisions were included in the LLC laws so that an LLC would lack the corporate characteristic of free transferability of interests.
After the check-the-box rule, the legislatures could have removed the default rule restricting transferability. They did not do so, in recognition that, in general, members will want to control transfers of membership interests so they can prevent unwanted outsiders from becoming participants in the management of their business.
7. Withdrawal of members
The early versions of the LLC statutes gave members the right to withdraw at any time and receive payment of the fair value of their membership interests. By giving members withdrawal rights that could lead to the dissolution of the LLC, the legislatures hoped to avoid the corporate characteristic of continuity of life.
After the check-the-box rule, many states amended their LLC statutes. Some now provide that a member may not withdraw from the LLC unless the operating agreement provides otherwise. Others provide that members may withdraw but treat the withdrawing members as assignees — which means they do not have a right to demand payment of the fair value of their membership interests. The reasons for this change were to provide the LLC with more liquidity and stability by locking in the members’ capital investments and to give certain estate planning advantages to family-owned LLCs.
The typical LLC act today has a default rule providing that the LLC will be managed by its members. The LLC acts in the early years had the same default rule. The original purpose of vesting management in members was to allow an LLC to avoid the corporate characteristic of centralized management. The check-the-box rule made that purpose irrelevant.
However, the legislatures chose not to change the default rule. They recognized that most LLCs will be managed by their members. In closely held entities, the owners will often want a management role to monitor their investment.
9. Management formalities
In keeping with the legislative intent to provide a flexible entity, the LLC statutes impose few restrictions on the manner in which an LLC may be managed. Meetings of members or managers are not required. Nor, in general, are quorums, the setting of record dates, the keeping of minutes, and other management formalities found in corporation statutes. The members may decide what actions the LLC will take, and how these actions will be taken, in as formal or informal a manner as they wish.
Today’s LLC statutes typically provide that an LLC is dissolved upon the consent of the members or upon the happening of an event set forth in its operating agreement or at a time set forth in the formation document. They also provide that unless the operating agreement provides otherwise a member’s death, bankruptcy, incompetency, retirement, resignation, expulsion, or withdrawal does not cause an LLC’s dissolution.
The dissolution provisions of the original statutes required dissolution under more events. Some even restricted an LLC’s duration to 30 years. This was so that an LLC would not have the corporate characteristic of continuity of life. After the check-the-box rule was enacted, the statutes were amended to give LLCs the advantage of continuity of life.
H. LLC case law today
“LLC law” is not only made by state legislators. It is also made by judges. By LLC case law we mean cases involving the internal governance of LLCs and cases adjudicating the rights, liabilities, and duties of members and managers.
There was not a substantial number of LLC cases decided in the 1990s. But, the number has been steadily increasing in the 21st century. Some cases require the courts to interpret an LLC statute. When interpreting a statute, a court’s primary goal is to evince the true intent and purpose of the legislature. Other LLC cases have required the courts to interpret an operating agreement. In these cases, the courts apply the same principles of contractual interpretation that they apply to other kinds of contracts.
Some LLC cases involve attempts to impose liability on a member. These attempts generally take one of the following forms: (1) an attempt by a third party to hold a member personally liable for the LLC’s debts or obligations, (2) an attempt by a third party to hold a member liable based on the member’s participation in the LLC’s wrongful conduct, (3) an attempt by the LLC, a manager or member to hold a member liable for breaching a fiduciary duty, or (4) an attempt by a member to hold another member liable for breaching the operating agreement.
There are also cases where a manager is sued by a member or an LLC for a breach of fiduciary duties. In some of the cases, there was a provision in the operating agreement defining the managers’ fiduciary duties that the court was called on to interpret. In others, the court had to apply the statutory standard or, if none, the common law.
Another source of litigation arises from the informal manner in which an LLC may be operated. In general, this is considered one of the LLC’s more desirable features.
However, that informality, when combined with the few statutory provisions dealing with management found in some LLC statutes, can lead to litigation over whether the person purporting to act on the LLC’s behalf actually had the authority to do so.
Understanding LLC law is a must for anyone owning, managing, or advising an LLC. And it’s particularly helpful to not only be familiar with the current state of LLC law, but with the history of that law, too.