By Kyle Brantley
The time-tested principle of having “skin in the game” rings true in many aspects of life. When individuals have something on the line to lose, they are more likely to be invested in the ultimate success of the venture at hand. For example, a company may want to utilize an Employee Stock Ownership Plan (“ESOP”) so that employees can gain a piece of company profits and therefore potentially be more incentivized to work harder in the interest of their own personal wealth.[1] The same basic concept of having “skin in the game” can be utilized to highlight a potential flaw of today’s most popular form of business organization: Limited Liability Companies (“LLCs”).[2]
Up until the end of the eighteenth century, almost all business entities were formed as either sole proprietorships or general partnerships.[3] As corporations became more prevalent in the next two centuries, founders had to be extra deliberate in weighing the pros and cons of opening themselves up to the personal liability of general partnerships versus footing the bill for the “double taxation” feature of corporations.[4] The Wyoming state legislature cracked open the door to a new option with the first domestic LLC in 1977.[5] This brand-new form of business organization combined the best of both worlds and was predominately motivated by a desire for a lower total tax burden; notably, members of LLCs enjoy limited personal liability for both debts of the organization and tort liability of other members.[6] In the next decade, Florida was the only other state to follow in Wyoming’s footsteps in 1982.[7]
The mid 1990s saw an elevated level of adoption, however, as eighteen states implemented LLC legislation in 1993 alone.[8] By 1996, all fifty states had adopted LLCs as a form of entity creation.[9] Astonishingly, 600,000 LLCs were in operation in the United States by 1999.[10] By 2007, LLCs were indisputably “king-of-the-hill among business entities” as twice as many LLCs were organized when compared to business corporations.[11] The quick nationwide ascension of LLC legislation at the state level was driven by innovation and competition among the states.[12]
Since LLCs essentially cut the potential tax payment of traditional corporations in half, experts have pontificated that the boon in LLCs has created “big holes in the federal corporate tax base” that will ultimately lead to sizeable revenue losses for the government.[13] While much of the conversation around the proliferation of LLCs has focused on the diminished tax revenue, not enough attention has been given to the hundreds of thousands of businesses that have newfound limited liability protections.
Sole proprietorships and general partnerships create unlimited personal liability for the partners.[14] The misconduct of one partner can financially ruin another partner who is not at fault for horrid behavior, potentially leading to significant tort liability. In a business deal, however, creditors and vendors can rest assured, knowing that not only will the business assets be available in the event of nonpayment, but the personal assets of the partners will be available to repay their losses as well. This availability of additional funds for repayment can bring more confidence to business dealings. This full personal debt and tort liability exposure can also lead to safer behavior and less risk taking on the part of the business owners. Since LLCs take away this personal liability, their members may be more inclined to make less prudent decisions since there is a cap on their financial exposure. The lack of personal liability repercussions can also lead to more lackadaisical membership inclusion since the misfeasance of one member will not open up other members to personal liability.
Unfortunately, many underprivileged or underinformed communities do not have access to attorneys to help with the logistics of organizing an LLC and therefore are far more susceptible to personal liability via sole proprietorships and general partnerships.[15] Most general partnerships in existence today are frequently businesses that are formed without legal advice.[16] This dearth of liability protection can lead to ruined businesses, personal tragedy, and an inability to transfer wealth to the next generation. Attorney access at the business formation stage should not be the make-or-break moment for businesses in our country.
This blog post does not attempt to prove that more creditors have been shortchanged or that more risky deals have been undertaken because of the proliferation of LLCs. Instead, the fact that LLCs are now the norm simply begs the question of what, if anything, the general populace and the government have gained from this relatively new business entity and whether it is equitable to have two vastly different outcomes for business owners based solely on their access to attorneys in the early stage of business formation.
[1] See Mary Josephs, Six Reasons Why Now Is a Good Time to Consider an ESOP, Forbes (May 28, 2020, 4:13 PM), https://www.forbes.com/sites/maryjosephs/2020/05/28/six-reasons-why-now-is-a-good-time-to-consider-an-esop/?sh=41090015ef11.
[2] See generally David Gindis & Martin Petrin, Economic Analysis of Corporate Law (Apr. 10, 2020), in Encyclopedia of Law and Economics 11 (Alain Marciano & Giovanni Ramello eds.).
[3] See Susan Pace Hamill, The Story of LLCs: Combining the Best Features of a Flawed Business Structure, in Business Tax Stories 295, 304 (Foundation Press 2005).
[4] See Howard Friedman, The Silent LLC Revolution – The Social Cost of Academic Neglect, 38 Creighton L. Rev. 35, 40 (2004).
[5] See The Complete History of the LLC, Wyoming LLC, https://www.wyomingllcs.com/history-of-the-llc/ (last visited Apr. 13, 2022).
[6] See Friedman, supra note 4, at 42.
[7] See Hamill, supra note 3, at 296.
[8] Id. at 297.
[9] Id.
[10] Id.
[11] See Rodney Chrisman, LLCs Are the New King of the Hill, 15 Fordham J. Corp. & Fin. L. 459, 460 (2010).
[12] See Hamill, supra note 3, at 303.
[13] See Hamill, supra note 3, at 309.
[14] See Friedman, supra note 4, at 40.
[15] See Andre M. Perry et al., Black-Owned Businesses in U.S. Cities: The Challenges, Solutions, and Opportunities for Prosperity, Brookings (Feb. 14, 2022), https://www.brookings.edu/research/black-owned-businesses-in-u-s-cities-the-challenges-solutions-and-opportunities-for-prosperity/.
[16] See Friedman, supra note 4, at 49.
