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Have you ever wondered how, or why, the first Delaware Limited Liability Company was established?
Before 1800, almost every business was either a sole proprietorship or a partnership. In both cases, the owner(s) of the business were responsible for all the debts and actions of the business. In those days, business owners had unlimited liability.
In 1977, when the state of Wyoming first passed legislation allowing a new type of company called a Limited Liability Company (LLC), hardly anyone noticed. Today, over two-thirds of all new companies formed are LLCs.
Before the establishment of the LLC, the combination of limited liability and pass-through tax treatment could only be acquired through a Sub-Chapter S Corporation, which 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.
As businesses started to become large, national and international organizations, 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.
This very successful company made gunpowder, which in those days was used daily by many Americans. Handling gunpowder can be extremely dangerous, so the DuPont family wanted to find 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 people 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. In fact, the Delaware corporation laws soon became the model for other states, which is still the case today.
While Delaware corporations allowed their 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, such as holding regular stockholders meetings, keeping minutes of those meetings and managing company funds separately from personal funds, just to name a few.
When these regulations were not followed, lawsuits ensued, and the court often stripped these rights from the corporations' owners. This was called piercing the veil of the corporation. By the 1990s, it was quite common for courts to pierce the veil of corporations, leaving the owners with unlimited liability.
In order to solve the problem of vanishing 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.
The creation of the LLC allowed for 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 the entity for almost 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 LLC Act.
Since Delaware led the way on LLC law, the Delaware LLC still has the reputation of offering the most protection to business owners. From the time the Delaware LLC Act was passed, in October 1993, the Delaware LLC has 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:
Both scenarios are valid uses of an LLC Operating Agreement, and both illustrate the flexibility and necessity of owners drafting their own Operating Agreements.
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.Form a Delaware LLC Now!
The HBS Blog offers insight on Delaware corporations and LLCs as well as information about entrepreneurship, startups and general business topics.
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