Federalism, Regulatory Competition, and the Limited Liability Movement: The Coyote Howled and the Herd Stampeded

Abstract

I. INTRODUCTION Choice of business entity decisions historically have involved considering and balancing three factors: (1) the extent to which owners and managers are personally liable to business creditors and tort victims under the applicable commercial law; (2) the tax and regulatory treatment of the business entity, including whether the entity and its owners will be subject to single or double taxation; and (3) the owners' current investment preferences and need to attract additional capital to the entity.1 Focusing on these factors, United States business organization law has undergone fundamental change since 1988. The limited liability company (LLC) emerged as a significant new organizational form,2 and the traditional general partnership and limited partnership forms mutated to permit limited liability protection for owners that historically had unlimited personal liability.3 As a result, business owners are not forced to suffer the tax disadvantages resulting from state law incorporation in order to obtain corporation-like limited liability protection. This change resulted from an elaborate interplay between two separate spheres that influence the selection of U.S. business entities-federal income taxation and state business organization law. The momentum for this change rapidly accelerated when the Internal Revenue Service (IRS) pronounced that Wyoming LLCs, which provide limited liability protection to all owners and managers, would receive favorable partnership taxation.4 By 1996, all fifty states and the District of Columbia had enacted LLC statutes. Following on the heels of the LLC revolution, Texas created the limited liability partnership (LLP) in 1991,5 and thereby permitted general partners in professional partnerships to avoid joint and several malpractice liability by filing a registration statement and using the "LLP" appellation in the partnership name.6 The remaining 49 states and the District of Columbia quickly enacted LLP legislation, and several states extended the LLP concept to limited partnerships (LLLPs), in which general (but not limited) partners historically have joint and several liability for entity debts and obligations.7 Although the de-coupling of partnership tax classification from personal liability finally occurred in 1988, it had its antecedents in the IRS's relaxation of tax classification rules with respect to limited partnerships. After steady growth in the early 1990s, it climaxed in 1996 when the IRS issued regulations providing that most multiple member unincorporated business organizations are taxed as partnerships, unless the organization makes an affirmative election to be taxed as a corporation.8 When the regulations were issued, any requirement that unincorporated business organizations retain partnership-like business characteristics to obtain partnership federal income tax treatment disappeared. The recent history of this U.S. business organization law revolution started with Wyoming's entrepreneurial creation of the LLC alternative9 and the resulting pressure on traditional federal entity tax classification rules. The federal tax regulators eventually responded by changing the classification rules to permit taxation of limited liability firms as partnerships. This change was undertaken with a focus on federal tax law and an indifference to the state law sphere. These tax changes enabled massive and rapid state legislative reaction to eliminate personal liability for organizational debts and obligations in order to enhance the individual states' pro-business environments.10 As the state legislatures rushed to created LLCs, LLPs, and LLLPs, little attention was paid to theoretical or normative aspects of the extension of limited liability protection to these firms.11 Although some commentators adopt a triumphal state-law-first attitude when discussing the LLC's emergence,12 the states' uncritical adoption of limited liability in reaction to tax regulatory changes can be viewed as a "race-to-the-bottom. …