COMBINING LIMITED LIABILITY AND TRANSPARENT TAXATION: LESSONS FROM THE CONVERGENT EVOLUTION OF GMBH & CO. KGS, S CORPORATIONS, LLCS, AND OTHER FUNCTIONALLY EQUIVALENT ENTITIES.

• Author: Roder, Erik

INTRODUCTION I. THE ATTRACTIVENESS OF COMBINING LIMITED LIABILITY AND TRANSPARENT TAXATION A. Attractiveness of Limited Liability B. Attractiveness of Transparent Taxation II. PATH ONE TOWARDS A TTLLE: COMBINATION OF LEGAL FORMS A. The German Solution: GmbH & Co. KG B. The Australian Solution: Trading Trust III. PATH TWO TOWARDS A TTLLE: OPTIONALITY OF TRANSPARENT TAXATION A. The U.S. Solution (1): S Corporation B. The French Solution: SARL de Famille & Co IV. PATH THREE TOWARDS A TTLLE : CREATION OF A BESPOKE ENTITY A. The U.S. Solution (2): LLC B. The UK Solution: LLP V. DETERMINANTS OF PATH DEPENDENCIES IN THE CONVERGENT EVOLUTION OF TTLLES A. High Hurdles for Using Path One 1. Limited Liability 2. Transparent Taxation 3. Control B. Default Character of Path Two C. Split Competences as Catalyst for Path Three VI. LESSONS FROM THE CONVERGENT EVOLUTION OF TTLLEs A. Demand for TTLLEs Is Universal B. Availability of TTLLEs Reduces Tax-Induced Distortions C. Evolution of TTLLEs Advanced the Law of Business Organizations D. Availability of Transparent Taxation and Entity Taxation Should Be Liberalized E. TTLLEs Resulting from Paths One and Three Should Be Carefully Rationalized CONCLUSION INTRODUCTION

From the middle of the twentieth century onwards, forms of business organization that combine limited liability and transparent taxation have proliferated among developed economies. Such tax transparent limited liability entities (TTLLEs) can nowadays be found, for instance, in all member states of the G7. (1) Important examples include the GmbH & Co. KG in Germany and the S corporation and the Limited Liability Company (LLC) in the United States. Businesses that are organized as TTLLEs are typically, though not necessarily, small or medium-sized enterprises (SMEs) and privately held.

The rise of TTLLEs is remarkable because they are essentially an anomaly. Traditionally, all major jurisdictions have been marked by a neat separation of limited liability and transparent taxation. Prior to the emergence of TTLLEs, only corporations featured a liability shield that protected all owners of a business from liability for business debt. Business profits of a corporation are--invariably--by default taxed at the entity level, (2) and not directly in the hands of its shareholders. To put it differently, a corporation is, as a matter of principle, non-transparent (or opaque) for income tax purposes. By contrast, forms of business organization that do not provide a liability shield, i.e., sole proprietorships and general partnerships, are--equally invariably--by default tax transparent in all major jurisdictions. (3) This means that business profits are taxed directly in the hands of the sole proprietor or of the individual partners.

If one takes a closer look and compares how limited liability and transparent taxation are combined in different jurisdictions, two striking facts about TTLLEs become apparent. First, while almost all jurisdictions feature TTLLEs, their practical importance as business vehicles differs widely. In Germany and the United States, a substantial share of total business activities is conducted through GmbH & Co. KGs, S corporations, and LLCs. However, in many other jurisdictions, such as Australia, Canada, and the United Kingdom, the relevance of TTLLEs as business vehicles ranges from limited to marginal. (4) Second, while TTLLEs are functionally equivalent to a large extent, their underlying "legal mechanics" or structure can be very different: A GmbH & Co. KG is a combination of two business entities--a corporation and a limited partnership. An S corporation is a plain-vanilla corporation that has opted for a special tax regime. An LLC can best be described as a hybrid business entity that combines elements of partnership and corporation.

The Article sets out to answer three main questions. First, what accounts for the difference in the prevalence of TTLLEs in different jurisdictions? Second, why are TTLLEs of different jurisdictions structurally so different, and which factors determined the type of TTLLE that would emerge in a given jurisdiction? Third, what can be inferred from the comparative analysis of TTLLEs about the interaction of organizational law and tax law and about how both areas of law could be enhanced?

To answer the first question, the Article analyzes why entrepreneurs find combining limited liability and transparent taxation attractive. In all jurisdictions, protection from liability for business debt is of pivotal importance to the owners of a business, irrespective of its size. Variations in the prevalence of TTLLEs among jurisdictions can be accounted for, to a large extent, by differences in the design of income tax systems that influence the degree to which TTLLEs are attractive as business vehicles (Part I).

In order to explain the structural differences among TTLLEs, the Article examines six TTLLEs from five jurisdictions: Australia, France, Germany, the United Kingdom, and the United States (Parts II, III, and IV). Each jurisdiction is represented by the TTLLE that is most relevant as the organizational form for active (5) businesses: the GmbH & Co. KG for Germany, the trading trust for Australia, the SARL de famille for France, and the Limited Liability Partnership (LLP) for the United Kingdom. For the United States, two TTLLEs are examined: the LLC and the S corporation. The comparative analysis reveals that structural differences among TTLLEs are the result of convergent legal evolution. (6) Just as comparable evolutionary conditions caused dolphins (mammals) and sharks (fish) to develop a similar body form and coloration, the pressure exerted on different legal systems by the demand for combining limited liability and transparent taxation led to the emergence of functionally equivalent, but structurally different, TTLLEs. In total, there are three different "evolutionary paths" leading to a TTLLE: the combination of two legal forms (Path One), making transparent taxation optionally available for corporations (Path Two), and the creation of a bespoke new business entity (Path Three). Legal transplants play (almost) no role in the evolution of TTLLEs. This is not surprising if one considers that the creation of a TTLLE by means of a legal transplant would require substantial changes in two complex and distinct areas of law--the law of business organizations and tax law.

The six TTLLEs examined in this Article provide two examples for each of the three paths that lead to a TTLLE. Taken together, their history allows one to identify key parameters that determined which type of TTLLE would emerge in a given jurisdiction (Part V). As soon as the incentive of combining limited liability and transparent taxation is strong enough, entrepreneurs try to set up TTLLEs via Path One by combining a form of business organization that features a liability shield with another one that is taxed transparently. The result is a do-it-yourself TTLLE, such as the German GmbH & Co. KG. Path One TTLLEs do not require a deliberate policy decision, only tolerance or inaction by courts and legislators. From the perspective of entrepreneurs, this is a key advantage, as legislators are rather reluctant to meet entrepreneurs' demand for a combination of limited liability and transparent taxation. There are, however, high hurdles to overcome in order to create a Path One TTLLE. In some jurisdictions, it is simply not possible. If Path One is not available, entrepreneurs have to wait for the legislature to create a TTLLE via Path Two or Three. If legislators provide for a combination of limited liability and transparent taxation, they usually choose Path Two and allow corporations to opt for transparent taxation. Typically, legislators only want to grant the benefit of transparent taxation in a targeted way, which means that Path Two TTLLEs are only available to businesses that meet certain requirements--for instance, being not too large, being active in certain economic sectors, having not too many owners, etc. The creation of bespoke TTLLEs via Path Three becomes more likely if competences for the law of business organizations and tax law are split among different legislatures.

Finally, the Article draws lessons from the convergent evolution of TTLLEs about the interaction of organizational law and tax law and develops recommendations for the enhancement of both areas of law (Part VI). First, while the design of the tax system has a large influence on the attractiveness of TTLLEs, there is, under a traditional income tax system, always a substantial group of businesses for which combining limited liability and transparent taxation is beneficial. The demand for TTLLEs is thus universal. Second, the availability of TTLLEs of all types reduces tax-induced distortions as to the choice of business organization by eliminating the trade-off between limited liability and transparent taxation. TTLLEs have thus a useful role to play, and it is a positive development that more and more jurisdictions satisfy the demand for TTLLEs. Third, the often reviled distortive effect of tax considerations on the choice of business entity, which drove the evolution of TTLLEs, has in fact positively influenced the law of business organizations. Distortive taxation has acted as a catalyst for its development and sparked innovations that would probably not have occurred otherwise, or only much later. Fourth, the Article recommends making transparent taxation and entity taxation optionally available to all types of business entities, as far as practically feasible. Apart from concerns about practicality, there are no sound reasons for linking the applicable tax regime to the legal form in which a business is operated. Finally, it is suggested to carefully rationalize the organizational law of TTLLEs while maintaining the diversity of forms that has evolved.

1. THE ATTRACTIVENESS OF COMBINING LIMITED LIABILITY AND...