The limited liability company: a catalyst exposing the corporate integration question.

• Author: Hamill, Susan Pace

The rise of the domestic limited liability company (LLC)(1) from obscurity to its present position as a viable, mainstream alternative to the corporation or partnership was met with enormous enthusiasm by the business community and the practicing bar.(2) First introduced by the State of Wyoming in 1977(3) and recognized by the Internal Revenue Service (IRS) as a partnership for federal income tax purposes in 1988,(4) the LLC offers for the first time a domestic entity that combines the tax advantages of a partnership with limited liability protection for all members, an advantage commonly associated with corporations.(5) The advantages of the partnership tax provisions include one level of tax at the owner level, flexible rules to allocate profits and losses among the owners, and the opportunity for owners to deduct losses or receive distributions attributable to the partnership,s liabilities.(6) By contrast, corporations are taxed at both the entity and the shareholder level,(7) unless they elect subchapter S, which taxes closely held corporations only once - at the owner level - under a set of rules far less favorable and flexible than the partnership provisions.(8) However, unlike shareholders of corporations who bear no statutory personal liability for the corporation's debts,(9) under the partnership statutes, at least one partner must bear personal liability for the debts and obligations of the partnership.(10)

By combining the best of both worlds, partnership taxation and limited liability, the LLC revolution can be characterized as tax driven.(11) Nevertheless, some commentators believe that it is the LLC's superior business provisions that will cause LLCs to continue to rise in popularity.(12) Although the LLC's business provisions may be characteristic of either partnerships or corporations, in toto they produce a truly unique and new business entity that cannot be aligned categorically with either of the more traditional forms.(13) For example, the statutory provisions addressing the management and control of the LLC generally vest agency authority and governance rights in all members, as if they were partners in a general partnership. However, LLC members, unlike general partners, can adopt a management structure resembling those of corporations or limited partnerships by appointing managers. The LLC's managers, holding the power to make important policy decisions and to bind the LLC in day-to-day business transactions, take on the roles held both by general partners of limited partnerships and by corporate directors and officers.(14)

Regardless of whether the motivation is tax or business related, the use and acceptance of LLCs as a serious alternative to the partnership and the corporation exponentially increased between 1988 and 1995 and will probably grow more each year.(15) Indeed, some commentators believe the LLC will largely replace the partnership and the closely held corporation and emerge as the dominant form of business for nonpublicly traded entitles.(16)

The rise of the LLC, however, has not been greeted with uniform zeal. Said one critic: "The federal government has opened up a candy store."(17) This pithy comment metaphorically sums up the underlying and often unarticulated concern hidden in the shadows of the LLC euphoria. Some commentators have expressed concern that the LLC could undermine the policy behind the two-tier tax imposed on corporations and shareholders, or the restrictions under the subchapter S regime, or both.(18)

For over fifty years, scholars, practitioners, and legislators have debated whether the tax imposed at both the corporate and shareholder levels represents sound tax policy - whether this two-tier tax should be eliminated or mitigated.(19) This question, commonly referred to as the "corporate integration issue," arguably represents one of the most important tax policy issues confronting U.S. lawmakers today. Because the corporation historically has been the only domestic entity to offer limited liability protection for all owners, and because the corporate tax regime applies per se to all domestic corporations,(20) the question whether, and under what circumstances, limited liability protection should carry the price of the corporate tax must be resolved before one affirmatively answers the corporate integration issue.(21) Because LLCs offer limited liability by statute and partnership taxation, they appear to offer a new mechanism to achieve corporate integration even though U.S. lawmakers have not yet sanctioned corporate integration in any form.(22) This observation has led some commentators to question whether LLCs represent an effort by the states to achieve corporate integration's benefits inappropriately without the approval of Congress.(23) The LLC's strongest critics view the LLC as a direct threat to the corporate tax base, arguing that LLCs should either be taxed as corporations or legally limited in some other fashion.(24)

This article demonstrates that the rise of the LLC will not materially reduce the corporate tax base, and uses the LLC phenomenon to expose two major problems in current corporate tax law: the intolerable inequities of imposing the corporate tax on small corporations, and the distortions caused by, as well as the conflicting signals within, the corporate tax structure as applied to large corporations. Part I attributes the energy that fuels the LLC's rise to Congress's failure to address the corporate integration question. The number of new state LLC enactments and LLC filings showed minimal activity until the IRS confirmed partnership status for the LLC form, at which point there was explosive growth in new state enactments and LLC filings. This evidence illustrates that the sole attraction of this new business form was the desire to obtain statutory limited liability and flow-through taxation under the partnership regime - the void left open by the corporate integration question. Moreover, as new LLC state filings showed geometric growth, both the IRS and Congress were confronted with the effect of LLCs on the different tax regimes that are accorded partnerships and corporations - another aspect of the corporate integration issue.

Part II examines the critical question of whether the increased use of LLCs amounts to an unsanctioned backdoor to corporate integration, and concludes that it does not. Even before the LLC developed, small businesses who could afford the necessary transaction costs were able to achieve limited liability and one level of taxation. Part II notes that LLCs cannot threaten tax revenues collected from publicly traded corporations, because the tax law forces all publicly traded entities to bear the corporate tax. Part II further illustrates that LLCs theoretically challenge tax revenues collected from larger, nonpublicly traded corporations, where the asset base and level of ownership has expanded beyond the closely held range. Part II concludes, however, that this theoretical ability to undermine the corporate tax will not materialize because certain practical constraints, mainly the unwillingness of tax-exempt and foreign investors to purchase noncorporate equity, will prevent larger nonpublic businesses from using LLCs to avoid the corporate tax.

Part III explores the impact of the increased use of the LLC form on the substantive resolution of the corporate integration issue, by focusing separately on closely held corporations with a relatively modest asset base and on larger corporations where the asset base and ownership level has extended beyond the closely held range. Careful tax planning always allowed closely held businesses the opportunity to obtain limited liability and one level of tax. However, because the LLC offers these benefits with minimal transaction costs, closely held businesses will continue to choose the LLC over the corporation form in large numbers without examining the LLC's business benefits or detriments. Thus, it is impossible to tell whether or not the LLC offers material business advantages over the close corporation. This preference for the LLC exposes the inequities of applying the corporate tax to small incorporated businesses as compared to the more favorable and flexible partnership tax provisions enjoyed by LLCs. Consequently, by exposing these inequities, the increased use of LLCs has demonstrated the demand for some form of corporate integration, at least for closely held corporations.

Part III recognizes that, because LLCs do not pose a threat to the taxation of larger corporations, lawmakers could leave LLCs alone and maintain the corporate tax in its current form without affecting the number of larger businesses needing to incorporate. Part III argues, however, that as LLCs continue to multiply, their sheer numbers, combined with their theoretical challenge to the corporate tax revenues paid by these larger corporations, will make it increasingly difficult for lawmakers to avoid the corporate integration issue. The LLC's ability to provide limited liability combined with one level of tax under the partnership provisions brings to the surface the question of what role limited liability should play when imposing the corporate tax. Moreover, the practical reasons that prevent LLCs from being a real threat to the corporate tax paid by larger corporations help expose certain fundamental problems within the corporate tax structure: the distortions in investment decisions caused by the distinctions drawn between taxable and tax-exempt and foreign investors, as well as the disparate treatment between debt and equity.

1. The Rise of the LLC and the Corporate Integration

   Issue

   1. LLC's Before the Recognition of Partnership Status

      The LLC's very creation is linked to the corporate integration issue. After a failed attempt in Alaska, the Hamilton Oil Company, on behalf of certain foreign oil and gas clients, lobbied the Wyoming legislature to create a...