Raising the Corporate Veil

Wyoming, home to the first LLC. Image: Pixabay | CC0 1.0

For actors looking to take advantage of the U.S.’s transformation into a global offshore haven, there are few tools more popular than limited liability companies (LLCs). From states like Nevada and Wyoming to high-rises in Miami and New York, LLCs have become one of the most prominent features of the U.S.’s shell company industry. And due to the U.S.’s lack of a beneficial ownership registry, actors both foreign and domestic continue to use LLCs to mask their identity – and their wealth.

The Kleptocracy Initiative’s Casey Michel spoke with Susan Hamill, a professor at the University of Alabama’s Law School and leading expert on LLCs, about how LLCs first originated – a topic on which she’s written extensively – as well as why they’ve grown in such prominence for those looking to stash their wealth offshore.

How did LLCs first come about?

The background and history of LLCs – that’s a pretty big topic. I have to remind you of a very important, really historical development, and a function of the law of business organizations, which is that a business organization is a creature of state law. And you might say, “So what?” But first-year law students learn right off the bat that Congress has the power to regulate interstate commerce, commerce amongst states, and since the early 20th century that power has been interpreted by the Supreme Court very broadly. Basically, federal law has the ability if they choose to regulate virtually all economic and commercial activity in the United States. In other words, they have supremacy over the states.

But the law that creates the statute for corporations – for LLCs, for partnerships – comes in each individual state. That’s why we have 50 state corporate statutes, 50 state LLC statutes, 50 state partnerships statutes, 50 state limited partnership statutes. So in order to understand LLCs, you have to first grapple with this irony, or this inefficiency, that the foundation of business organization law remains at the state level, not at the federal level. That is a creature of historical development.

Had business organization law been a function of federal law, you would not have had LLCs develop the way they did. Business organization law would look very different if it was simply a function of federal law. It would be arguably a whole lot more efficient – but the other side of the coin would be perhaps less creative, because you would not have the ability of the state legislatures to invent new business organization forms. Believe me, it’s not your average state legislator who’s doing that. The average state legislator doesn’t understand business organization law. But every state has a committee of lawyers that are members of that state’s bar, that practice in the business area, and who advise the legislators and who make suggestions. So you have a lot of creativity.

As you’ve detailed elsewhere, Frank Burke and his colleagues formed the first LLC in Wyoming in 1977. Why is it that he and his team ended up working with the Wyoming legislature to create LLC?

Frank Burke and his wildcat oil driller clients – they went to Alaska first. That proposal died because of a political squabble that had nothing to do with the bill, although we could not get to the nub of what the fight was about. Who knows what it was about – legislators kill each others’ bills all the time.

I interviewed Frank Burke before he died in about 2010 – he gave me copies of all his documents. Basically, what they wanted was a state where the legislature was accessible. Think about it: In Alaska and Wyoming, it’s a whole lot easier to get to the legislators and go have coffee, or go hunt or whatever, than getting to New York or California and penetrating their legislature. So they deliberately went to a less formal, less populous state, where the individual legislators were more accessible. It didn’t work in Alaska, so they said, “Okay, we’re going to take our proposal to Wyoming.” And the Wyoming folks welcomed them with open arms.

Frank Burke and his clients, they were wildcat oil drillers – they did a lot of exploration offshore, and wanted a domestic US business entity form that offered limited liability and partnership taxation. They did a lot of their explorations offshore, and for years they would organize their oil-drilling activity in things like Panamanian limitadas – foreign entities that offered the corporate liability shield to all owners and still qualified for US partnership taxation. Frank’s clients were having difficulties dealing with the Panamanian and other foreign governments, and what they wanted was a domestic, U.S. business organization form that offered limited liability and partnership taxation. The sub-chapter S corporation was never a viable alternative due to the sub-chapter S corporation rules. And they didn’t want the entity-level sub-chapter C.

This is where the creative part comes in. They could have just set up a US limited partnership and used a corporate general partner and minimally capitalized it, but they didn’t want that. So Frank and his clients said, “Why can’t we have a business organization that provides the corporate veil liability protection directly, and we’ll draft it so it otherwise leads to partnership tax rules?” And they did.

Was the creation of the LLC simply a matter of being in the right place at the right time? Or was the creation of the LLC inevitable?

That’s the $64,000 question. And I had extensive conversations with Frank Burke about this, because Frank was a bit upset at any sort of suggestion that LLCs were created to facilitate what was a lot of tax sheltering going on with unwise real estate deals, or any suggestion of what was, I don’t want to say dirty, but less wise business. But you had a perfect storm regarding the demands for crude oil from independent oil explorers at that time.

Having said that, you could have had somebody who was also very creative invent the LLC for real estate projects, though that was less likely because the big real estate projects, the big syndicated tax shelters, were being done in New York law firms, and DC law firms, and large LA firms, and they had perfected the limited partnership for that role. There was really no motivation for them to think outside that box. They had their regime going. Real creativity generally doesn’t come from the establishment – it comes from those on the fringes. So in that sense, I can say with some degree of insight given how much time I spent studying this, that it really wasn’t an accident that it came from the independent oil explorers.

Why did it take so long for the LLC to take off nationally?

The original proponents never benefitted from the LLC, because the LLC didn’t become a viable business organization form until 1988. That year, Revenue Ruling 88-76 was released, which pronounced that the Wyoming LLC, under its statutory provisions, could be federally taxed as a partnership. It took a little push, but other states – really, we’re talking about the lawyers on these bar committees – then saw that the Wyoming LLC was now legitimate. Once it was clear that partnership taxation would be allowed if some regulations were met, and the corporate liability shield did not make partnership taxation dead on arrival, then LLCs began expanding. Now most states are in their fifth-generation LLC statutes. And the LLC statutes of today barely resemble the first-generation statutes.

From your perspective, why have LLCs become so prevalent in the world of offshoring?

I’ve been asked a lot about that. LLCs are being used in ways that many good government types and thinkers would deem unwise. That’s a polite way of putting it. The issue is not just an LLC issue – it’s bigger than that. Remember that business organizations are creatures of state law. That means that if you can convince Nevada, for example, to permit wealth being hidden offshore through an LLC organized in Nevada, if you can convince the legislature to allow that, then off you go to the races. And other states, if they want to attract those kinds of uses for the LLC – because remember, any time you file a business organization there are fees, and the state collects revenue, so there’s motivation – so right there the principal reason is the state legislators, if convinced by the lawyers advising them (who often represent the clients who want to conduct these deals).

You might ask why we’re seeing this in the LLC as opposed to the corporation, so let’s go back to our friend, the federal income tax law. Because corporations, as I explained, are either taxed as entity C companies – and this offshore activity, they’re not going to want to mess with a C company. And they’re certainly not going to want to mess with an S company either, as foreign owners can’t be owners, debt doesn’t pass through, and you can only have one class of stock. The LLC has evolved, as a matter of state law, of being very contractually friendly, with more deference accorded to the operating agreement than any other business organization form. Meanwhile partnerships, and these include limited liability partnerships (LLPs), have had the strongest immutable fiduciary duties that can’t be whittled down to the nub in the agreement. Partnerships have a history of, let’s just say, a greater level of immutable fiduciary law, and LLCs have evolved to allowing more contractual freedom than even the corporation – and that’s a function of state law.

These days the LLC is being used for purposes that would make Frank roll over in his grave. And the first-generation LLC idea in the 1990s was that they wanted to give small business a way to get the liability shield and the benefits of partnership taxation without having to do things like set up S corporations.

In other words, the LLC was an attempt to provide a more transaction cost-free situation, because limited liability for all and partnership taxation had been going on for a while, just with taxation costs. They weren’t looking to facilitate the hiding of the true identity of real estate, of moving wealth offshore to make it harder to tax. They were looking for a way to facilitate legitimate business development without the transaction costs. But once you have the power of amending the statute to allow for whatever the lobbyists are pushing for in the amendment, you’re going to have a race to the bottom. The problems showing up in the use of LLCs are part of a deeper problem, which is the law of business organizations is initially at the state level, rather than the federal level.

Casey Michel is a researcher and journalist who has worked in the United States and former Soviet Union.

Susan Pace Hamill is Professor of Law and Honors Professor at the University of Alabama.