The Relationship of the Model Business Corporation Act to Other Entity Laws

By Clark, William H., Jr. | Law and Contemporary Problems, Winter 2011 | Go to article overview

The Relationship of the Model Business Corporation Act to Other Entity Laws


Clark, William H., Jr., Law and Contemporary Problems


For several decades after the Model Business Corporation Act (MBCA) was first prepared in 1950, (1) the business corporation was the entity of choice for organizing a business. That is now often not the case, and the competition from other entity forms raises important questions about the future development of the MBCA.

I

THE PREEMINENCE OF THE CORPORATE FORM FROM 1950 THROUGH THE 1980s

For much of American history, starting a business involved forming either a partnership or a corporation. (2) Originally, partnerships were what is known today as "general partnerships," but toward the end of the nineteenth century, the limited-partnership form was created. (3) The choice between the corporation and partnership forms was driven by two main concerns: liability and taxation. (4) Whereas a partnership left its owners vulnerable to personal liability for the obligations of the business, a corporation protected the owners by limiting liability to just the assets of the business. (5) On the other hand, the federal government taxed a corporation on both its profits and any payout to shareholders, referred to as "double taxation"; but only taxed the profits of a partnership as income to the partners, referred to as "flow-through" or "partnership" taxation. (6)

Early efforts to resolve the tension between liability and taxation concerns included the development of the limited partnership and the S-corporation, but each was an imperfect solution. The limited partnership provided flow-through taxation, but did not completely solve the liability problem; the S-corporation provided a full liability shield, but did not provide the best tax rules. So long as a limited partnership had at least one general partner that was liable for the obligations of the business, the remaining partners could be "limited" partners whose liability was limited to their investment in the organization. (7) The limited partners were relegated to the status of passive investors: if they participated in control or management, they could lose their liability shield. (8) The general partner was also required to be adequately capitalized so that there were substantial assets of at least one partner at risk for the liabilities of the business. (9) In contrast to limited partnerships, an "S-corporation" or "small-business corporation" provides the full corporate-liability shield, but only some of the benefits of flow-through taxation. Although the corporation is not subject to tax on its earnings, (10) there are significant restraints on both the ownership structure of S-corporations and the types of businesses that may qualify for S-corporation status. (11)

The tension between seeking full limited liability and flow-through taxation was generally resolved by choosing the corporate form and seeking to qualify as an S-corporation if possible. Thus, in states that enacted the MBCA, it was the most used of the state's entity laws from 1950 through approximately 1990. But all that was to change with the development of limited-liability companies.

II

THE ASCENDANCY OF LLCs

In 1977, Wyoming enacted the first statute authorizing the organization of limited-liability companies. The Wyoming statute was designed to create an entity with limited liability that would also be subject to flow-through taxation under the regulations of the Internal Revenue Service, known as the Kintner regulations, which provided that an entity could be taxed as a corporation if it had a preponderance of corporate characteristics. (12) These characteristics were (1) continuity of life, (2) centralization of management, (3) limited liability, and (4) free transferability of interests. (13) The Wyoming statute provided for limited liability and also provided default rules on the other factors that would result in partnership taxation. (14)

A decade after the enactment of the Wyoming statute, the IRS finally acknowledged that a Wyoming LLC qualified for flow-through taxation. …

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