Reassessing Corporate Separateness After Explosion Of LLC

One of the many controversies buffeting the legal community over the past few months has been the fate of the Corporate Transparency Act, part of a larger anti-money laundering initiative enacted by Congress in 2021, which was to require many corporate entities doing business in the U.S. to report the identity of their beneficial owners to the U.S. Department of the Treasury.

The CTA was enacted partially as a response to the increasing use of shell companies to hold property and transact business in the U.S., a trend that has been recognized by the Treasury Department for nearly two decades.¹ 

With the second Trump administration entering the scene, and amid several lawsuits²  challenging the provision, the Treasury Department promulgated new proposed regulations on March 21 implementing the CTA, which would significantly narrow the sweep of the act’s reporting requirements.³ 

Amid these recent changes, it is worth revisiting the underlying legal principles that govern shell companies, which can enable both illicit actors and recalcitrant debtors to reap financial rewards while staying one step ahead of both regulators and creditors.  This leads to a question:  Even if the CTA had been enforced as originally envisioned, would it have remedied the underlying problem? 

The answer from this perspective is largely no — at least as corporate law is currently applied.  This intent of this article is to both delineate the problem in more detail and propose possible evolutions in corporate law that could remedy the problems that motivated the CTA.

The fundamental benefit of shell entities is so-called corporate separateness, the default rule that companies — and their property — are legally distinct from their owners. 

Perhaps the clearest statement of this principle comes from the Supreme Court’s decision in United States v. Bestfoods: ⁴ 

“It is a general principle of corporate law deeply ingrained in our economic and legal systems that a parent corporation (so-called because of control through ownership of another corporation's stock) is not liable for the acts of its subsidiaries.” 

This iconic passage from Justice O’Connor’s opinion in Bestfoods has been quoted in more than 400 decisions in the 27 years since it was decided.  Similar incantations about corporate separateness preface virtually every American court’s analysis of a veil piercing or alter ego claim.  Justice O’Connor’s summary of the law — citing authorities largely from the 1920s through the 1960s — reflected the prevailing sentiment about the corporate entities predominating when Bestfoods was decided. 

But after more than a quarter century, there has been a marked shift in how corporate entities are used in the U.S.  Is it time to consider whether our economic and legal system today has changed so much that this general principle of corporate separateness should be brought up to date for current realities?

Since Bestfoods was decided, one type of entity has exploded in popularity: the closely held limited liability company.  The LLC is notoriously opaque and hostile to both regulators and creditors.  It is now frequently used to protect the assets of judgment debtors, or other malign actors, while permitting them to retain the practical benefit of significant wealth.⁵ 

The application of old principles of corporate separateness to this new corporate form has resulted in a trail of unsatisfied regulators and creditors.  This could not have been the intent of Justice O’Connor when Bestfoods was decided and when these bedrock principles of corporate law were first laid down.

 As described below, however, many of these ills could be remedied by shifting litigation burdens in cases involving certain particularly problematic types of closely held LLCs — all while protecting the legitimate investors and businesspeople. 

Of course, this would require recognition of the problem and subsequent intervention by judges and, potentially, legislators.  That will surely take time and continued attention, but this article is intended to shine a light on the issue and stimulate a conversation about reforms to bring integrity back to our corporate system. 

Limited Liability Companies  —  An Outsider’s View

“The purpose of limited liability is to promote commerce and industrial growth by encouraging shareholders to make capital contributions to corporations without subjecting all of their personal wealth to the risks of the business,” David Barber wrote in his 1981 paper, “Piercing the Corporate Veil.⁶ 

That limitation on liability was, historically, obtained by creating a corporation, which came with all the attendant requirements for corporate governance.  Those requirements compared unfavorably to the relatively nimble governance and management mechanics of the partnership.  

Enter the LLC.  Designed to combine the managerial agility of a partnership with the limited liability of a corporation, it was only in 1977 that the first limited liability company act was passed in Wyoming.  

Unlike shareholders in a corporation, owners in limited liability companies are referred to as members whose rights are set out in a membership agreement akin to a corporation’s bylaws.  Those members are not liable for the obligations of the entity even though they may also be managers of the entity — that is, the person with day-to-day control of the company.

The unique characteristics of limited liability companies make them infamously difficult for creditors or authorities to deal with. 

To begin, the members of an LLC — that is, the LLC’s owners — are rarely, if ever, identified in public corporate filings unless the member so chooses.  Thus, creditors and regulators cannot ordinarily even identify the fact that a debtor owns an LLC without resort to litigation or investigative subpoenas. 

That was the key problem that the CTA was designed to remedy.  But even once a relevant LLC is identified, a creditor of an LLC’s member cannot simply seize and sell the membership interest of the debtor under most states’ LLC laws.  Instead, a creditor’s remedy generally consists of a charging order requiring only that any distributions from the LLC be used to repay the creditor.  The opportunities for mischief are both plentiful and obvious, particularly in closely held LLCs. 

In those entities, it is ordinarily either the debtor or the debtor’s close associates or family members who decide whether and when to make distributions.  As a result, debtors can stymie creditors by simply declining to make distributions, or can cause the LLC to make payments to other affiliates of the debtor to evade seizure, which may ultimately be unwound, but only after costly and protracted litigation. 

Simply put, creditors or authorities almost surely have a time-consuming and expensive headache on their hands when confronted by a closely held LLC populated with a debtor’s friends and family.

And even in circumstances where a creditor can seize a debtor’s LLC membership interest,⁷  the creditor ordinarily has only the rights of a so-called transferee; the creditor cannot vote the membership interest to control the LLC unless the membership agreement permits it.  Naturally, most LLCs created to shield assets will not, in fact, permit it. 

Thus, even where an LLC owns a mansion that could satisfy a judgment or repay victims of a fraud, and a creditor successfully seizes a debtor’s 100% membership interest, the creditor likely cannot vote the LLC into selling the property.  In short, closely held LLCs are a bonanza for those wanting to protect their assets.

The Explosion of Closely Held LLCs Since Bestfoods

In light of these benefits, it may seem difficult to believe that LLCs did not take off in popularity when they were created in the 1970s.  Why?  Taxes. 

Until the late 1980s, it was not clear whether LLC income was taxed only once — so-called “pass through” taxation — or whether LLC income was taxed at both the entity level and at the level of the LLC’s members.  IRS Revenue Ruling 88-76, promulgated in 1988, determined that under certain circumstances, LLCs could be subject to the same pass-through taxation as partnerships. 

In the following decade, 40 states passed LLC acts permitting LLCs to be created under their respective laws.  Still, it was not until the IRS introduced the “check-the-box” rule in 1997⁸  that the pass-through taxation status of LLCs — and, in particular, single member LLCs— became settled.⁹ 

This led to an explosion in the number of single-member LLCs in the U.S.  The IRS reports data about single member LLCs (categorized as sole proprietorships) and multi-member LLCs (categorized as partnerships) in different places, but patterns are noticeable.

In 2001, three years after the decision in Bestfoods and four years after the check-the-box rule went into effect, the data shows only 126,000 nonfarm single-member LLCs in the U.S.¹⁰ By 2020, nearly 2.8 million such entities existed — an increase of more than 2,000%.¹¹  During the same period, receipts for nonfarm, single-member LLCs rocketed from $23 billion to $518 billion per year — a 22-fold increase.¹² 

LLCs with multiple members have also grown significantly in the decades since Bestfoods.  Between 2001 and 2020, multimember LLCs increased more than threefold from 808,692 to approximately 3 million.¹³  The overwhelming majority of these multimember LLCs appear to be closely held. 

Indeed, the most recent IRS data on partnerships, which includes multi-member LLCs, reflects that, for the tax year 2022, approximately 58% of such entities had three or fewer partners/members, and 83% had fewer than five partners/members.¹⁴ 

The IRS data on single- and multi-member LLCs suggests that as of the 2022 tax year, more than six million LLCs were active in the U.S.  Of those, more than 45% appear to be single-member LLCs, more than 75% appear to have three or fewer members, and approximately 90% appear to have five or fewer members.

In other words, the vast majority of LLCs seem to be the type of closely held entities that are most easily used to conceal assets from authorities or protect assets from creditors.  And this LLC-based asset-protection ecosystem has almost entirely developed in the decades after Justice O’Connor’s famous annunciation of “deeply ingrained” principles in Bestfoods.

To be sure, many amongst the flood of LLCs — and even closely held LLCs — do have legitimate uses.  And it is true that egregious abuse of LLCs can have remedies in some jurisdictions, such as fraudulent transfer and veil-piercing claims, although other jurisdictions have put up obstacles to such claims, including unusually short limitation periods. 

But pursuing these claims is time-consuming, expensive, and structurally difficult for plaintiffs, because much of the evidence required to carry the burden of proof is ordinarily in the sole possession of conflicted and uncooperative parties.  Though consequences may exist for failure to obey discovery requests, this exercise requires a lengthy process of motions to compel and motions for sanctions or adverse inferences. 

All of this has the practical effect of altering the economic realities of litigation and burdening our courts.  This is particularly — and perversely — true where the debtor and its affiliates actually have significant assets to spend on protracted litigation to stonewall creditors or regulators.

This cynical misuse of the corporate form compels creditors or authorities to accept unmerited discounts and enables debtors to reap a financial benefit from their own recalcitrance.  This could hardly have been the intent of the drafters of the uniform LLC acts, or of Justice O’Connor in Bestfoods.

New Principles for a New Era in the Corporate Form?

So, if Bestfoods laid down the principles for a bygone era, what now?  Stated differently, how can this dynamic be altered without unduly impacting legitimate LLCs?  Several possible avenues for improvement come to mind.

One possible solution would be to reverse the veil-piercing analysis for certain categories of LLCs that are unusually susceptible to misuse as a bad faith asset shelter to frustrate authorities and creditors. 

For example, the common law of veil piercing could put the burden on an LLC to demonstrate that there would be no injustice from maintaining corporate separateness where an LLC (1) has been funded by an adjudicated criminal, a judgment debtor or their efforts; (2) has three or fewer ultimate beneficial owners; and (3) consists of a majority of the beneficial owners who share a connection to the debtor other than the business of the LLC, for example, family ties.

If desired, this could be limited to LLCs that have little or no business with unaffiliated persons or entities —I n other words, LLCs whose primary purpose is to simply hold assets.  These entities do little or nothing to advance the goal of promoting commerce and economic development that underlies the principle of limited liability in the first place.

Another concept would be a presumptive restraining order or attachment of assets of an LLC when a judgment or forfeiture order has been entered against a member of the LLC, and that member or his or her family members are the beneficial owners of most of the LLC’s membership interests.  Here, the status quo would be maintained pending a more thorough analysis.

Assuming an appropriate bond or security is required from the creditor, the likelihood of meaningful injury to innocent LLCs seems low and proportionate to the legitimate benefits of the LLC form.  Here too, application of the rule could be cabined to circumstances where the LLC in question has few if any economic ties to innocent owners, thus protecting legitimate businesses that comport with the entrepreneurial spirit behind the principle of limited liability.

Creative debtors and illicit actors will surely seek out new ways to evade their legal obligations, and the above concepts are certainly not the only way to deal with the recent explosion in closely held LLCs.  But the rise of these now-pervasive entities is materially impacting the integrity of our legal and corporate governance system, and simply identifying the owners of these entities via the CTA will not, in itself, fix this problem. 

The “economic and legal systems” of today are simply not of the same ilk of those that confronted the Bestfoods Supreme Court more than a quarter century ago.  Blindly applying those same principles has enabled malign actors to get one step ahead of their legal obligations.  It’s time our legal system considers how to catch up to this new reality.