Have you ever thought about the history of the LLC - how, or why, the first Delaware Limited Liability Company was established.
Back in the 1800’s, businesses were classified as either a sole proprietorship or a partnership. In both cases, business owners were responsible for all the debts and actions of the business. Before Limited Liability Companies, business owners had unlimited liability.
The history of the LLC starts in 1977, when the state of Wyoming first passed legislation allowing a new type of company called a Limited Liability Company. Few business owners took advantage of the LLC at first, and the State of Delaware didn't offer LLCs until 1991. Though few noticed right away, this was a landmark day in business ownership and LLC history. Today, over two-thirds of all new companies formed are LLCs.
Before the establishment of the LLC, businesses could only acquire a combination of limited liability and pass-through tax treatment through a Subchapter S Corporation. Unfortunately, this label imposed severe limitations on the number of shareholders and did not allow anyone but individual taxpayers in the United States to become business owners. General corporations were eligible for the liability protection but not pass-through tax treatment, and partnerships were permitted pass-through tax treatment but not limited liability.
Over time, businesses became increasingly large, with ties across the world, no one person could realistically afford to be liable for an entire company's debts and actions. One good example was a Delaware partnership called E.I. DuPont de Nemours & Company, known as the DuPont Company. DuPont specialized in gunpowder, which in those days was used daily by many Americans. Handling large amounts of gunpowder can be risky, so the DuPont family searched for a way to save themselves from carrying unlimited liability for their gunpowder manufacturing plants, and the many people utilizing the volatile powder.
The state of New Jersey had the answer - it passed a law that allowed business owners to form a new type of entity called a corporation, which would protect the owners of the business from personal liability. Thus, New Jersey had created the legal concept known as limited liability.
Rather than move to New Jersey, the owners of the Dupont Company convinced Delaware lawmakers to create laws that allowed corporations to be formed in Delaware, just as they were in New Jersey. Delaware took the suggestion one step further, however, and made its laws less restrictive than New Jersey's. While Dupont was not the first LLC, there were certainly a landmark case. Since, the Delaware corporation laws were so business-friendly, they soon became the model for other states, which is still the case today.
While Delaware corporations allowed their business owners to limit their personal liability for the company's actions and debts, they had to fulfill a long list of responsibilities in order to preserve this protection. Business owners had to host regular stockholders meetings, keep minutes of those meetings and manage company funds separately from personal funds, just to name a few.
If these regulations were ever violated, lawsuits ensued, and the court often stripped these rights from the corporations' owners. This was called piercing the veil of the corporation. Throughout business liability history, it was quite common for courts to pierce the corporate veil and leave the owners with unlimited liability.
In order to protect a business owner’s limited liability, some lawyers decided to form a new type of entity, which guaranteed that the maximum liability of any owner was limited to his investment in the company. This type of company became known as the Limited Liability Company, or LLC.
When LLCs were first created, the goal was to create a hybrid entity in which both pass-through tax treatment and limited liability could co-exist, legally, for the first time.
The IRS largely ignored Limited Liability Companies for 11 years, until the state of Delaware revolutionized the legal world by drafting and approving a new form of company legislation that combined asset protection and limitation on member's personal liability with IRS-approved pass-through tax treatment. That groundbreaking company legislation is now known as the modern Delaware Limited Liability Company Act.
Since the State of Delaware led the way on LLC law, the Delaware LLC still has a reputation of offering the most protection to business owners. From the time the Delaware LLC Act was passed, in October 1993, the Delaware Limited Liability Company has since become the most popular entity available to people forming businesses.
Delaware Limited Liability Companies are extremely flexible and offer a custom internal company agreement, now more commonly referred to as an Operating Agreement, which both establishes and governs the LLC. Since business owners have freedom of contract to draft their own Operating Agreements any way they see fit, the result is business owners creating company structures that fit their unique situations perfectly.
Consider these two different situations:
Business A drafts an Operating Agreement that focuses on holding real estate assets while protecting the owners of the LLC from any potential bankruptcy or creditors resulting from the LLC's real estate holdings.
Business B, a family business, is run by several family members; their LLC's Operating Agreement assigns the rights and responsibilities of the LLC to particular family members, and also outlines specific rules of succession for the family business.
Both scenarios are valid uses of an LLC Operating Agreement, and both illustrate the flexibility and necessity of owners drafting their own Operating Agreements.
The history of the LLC is a relatively short one, though many changes have happened in the years that they've been available. This year, more than two-thirds of all new companies formed in Delaware, often called the Home of the Corporation, will be Delaware Limited Liability Companies.
Related Articles From Our Blog
The HBS Blog offers insight on Delaware corporations and LLCs as well as information about entrepreneurship, startups and general business topics.
Harvard can provide assistance throughout the life of your company. These custom services are the most popular with our clients: