Small Business History: Where LLCs Come From

Sep 5, 2017 | Greg Jackson

Starting a small business can be financially dangerous. But it used to be even worse.

Not so long ago, an entrepreneur could be personally on the hook if something disastrous happened at his company — if, for example, one of his drivers on the job plowed into a bus and injured a dozen people. The options weren’t great. An entrepreneur could form a corporation so that the corporate officers would not be personally liable for the judgments stemming from the accident’s lawsuits. For a start-up, however, forming a corporation could be (and still can be) a daunting task requiring a board of directors, officers, shareholders, meeting minutes, rigid bookkeeping, and double taxation (where the corporation pays taxes and then the officers and shareholders pay taxes on the money they receive from profits of the company).

Then the LLC came along.

It should come as no surprise that many new business start-ups in the U.S. now do so under the protection of an LLC (Limited Liability Company). Surprisingly, the LLC structure didn’t even exist until 1977, and didn’t really even begin to catch on until after 1988 when the IRS ruled that the Wyoming LLC structure would be treated as a partnership — not a corporation — for tax purposes. A survey showed that in 1993 there were only 3,000 LLCs in the country. By 2105, that number had grown to more than 21 million.

How did it come to be one of the best things to happen to small business?

What’s It Take to Run a Hair Salon?

By the late 1950s small businesses were feeling the pain of having to form a full-fledged corporation just for legal protections, even if the business was a hair salon. The process was cumbersome, expensive, and unnecessary. But business owners still wanted some personal legal liability protection. Businesses took their concerns to Congress, and in 1958 a law was passed allowing the formation of a Subchapter S Corporation, or what’s commonly known as an “S corp.”

An S corp limits liability to the assets of the company (just like a regular corporation) while the income “passes through” to the owners (like a partnership). But its creation still must follow the requirements involved in setting up a corporation. Nonetheless the S corp is still a popular choice for small businesses — even after the LLC appeared.

A Better Deal That Nobody Noticed

The LLC structure began in the mid-1970s. At that time, the sparsely settled state of Wyoming wanted to attract more businesses and satisfy farmers, ranchers, and store owners who wanted a more nimble company structure. Something easier to manage, less expensive to create, and more tax friendly. What the S corp was attractive because it allowed the company’s income to pass directly to the shareholders and would protect shareholders from personal liability, the S corp usually required a lawyer to set up, and it limited the number of shareholders. So Wyoming took the appealing features of the S corp and folded them into an entity the state called a Limited Liability Company. (Many make the mistake of thinking the LLC stands for Limited Liability Corporation.)

What made the LLC so great?

  • It had the pass-through revenue feature of the S corp
  • It eliminated the shareholder restrictions (an LLC can have an unlimited number of “members”)
  • It was easy to create and manage

But it didn’t catch on at first. No, the Wyoming LLC puttered along for 10 years until Delaware (the corporation capital of the country) took notice of what was going on out west, formalized the LLC structure, and got the IRS to approved the income pass-through feature nationwide.

The Glorious LLC

Unlike a corporation, an LLC doesn’t have to have a board of directors, annual meetings, or elected officers. At the time of creation a “certificate of formation” for the LLC is filed, accompanied by an operating agreement drawn up by the members. It is very flexible.

The LLC does have to be licensed by the state every year and have a Registered Agent, but that can cost less than $5 per month. For small businesses with a host of other costs, having an easy, fairly seamless business structure offers much needed stability. And creates a necessary separation between the business and the people running it.