The History and Challenges of America’s Dominant Business Structure

Before Congress created S corporations, entrepreneurs had two basic choices when starting a business.  They could form a regular C corporation, enjoy liability protection, but face two layers of federal tax at the corporate and individual level.  Or they could form a partnership, enjoy a single layer of taxation at the individual level, but sacrifice the umbrella of liability protection.

Neither choice was optimal for small and family owned businesses.  In 1946, the Department of Treasury suggested a third option – merging a single layer of federal tax with comprehensive liability protection.  President Dwight Eisenhower joined the cause, and promoted the passage of legislation to encourage small business growth and entrepreneurship. 

In 1958, Congress acted on President Eisenhower’s recommendation, creating subchapter S of the tax code.  In exchange for enjoying a single layer of tax, entrepreneurs electing S corporation status agreed to the following limitations:

• They were required to be a domestic enterprise;

• They were required to have a limited number of shareholders;

• They were limited by who those shareholders could be; and

• They could have just one class of stock.

How significant was the creation of subchapter S?  Consider that in 1958, the top income tax rate was 52 percent for corporations and 91 percent for individuals.  That means dividends paid by a C Corporation to a high-income shareholder faced an effective tax rate of 96 percent!  Even a shareholder with median family income faced an effective federal tax of more than 60 percent.  Creation of the S corporation was a huge step forward in eliminating a devastating double tax and encouraging small and family business creation in the United States.

Nearly a half century later, S corporations are the most popular corporate structure in America.  The IRS estimates that there were 3.2 million S corporation owners in the United States in 2003 – compared to approximately 2.1 million C corporations and 2.3 million LLCs and other partnerships. 

The popularity of S corporations has accelerated.  In just the last 10 years, the number of S corporations has grown from 2 to 3.2 million.  Small businesses are the cornerstone of the American economy, and S corporations are the cornerstone of America’s small business community. 

But while the S corporation community grew and evolved, the rules governing S corporations remained largely the same.  The number of shareholders is still limited, an S Corporation may have only a single class of stock, and the rules still limit who or what may own shares in an S corporation.    

Moreover, while S corporations are the most common form of business structure, the advent of the Limited Liability Corporation has given entrepreneurs a new, popular option when forming their businesses. 

LLCs have several advantages over S corporations.  There’s no limitation in the number of shareholders, no limitation on multiple classes of stock, and more flexible management options.  Because of this flexibility, the number of LLCs has grown nearly ten-fold since 1995, rising from fewer than 120,000 to more than a million today.  As a result, entrepreneurs starting a business today are more likely to choose an LLC than an S corporation.

The combination of rapid growth and the development of new, competing business forms presents two distinct challenges for S corporations.  First, Congress needs to modernize the S corporation structure to keep them viable and relevant.  Second, the S corporation community needs to defend against efforts to unfairly raise taxes on small and family-owned businesses. 

Modernizing the S Corporation Structure

The S corporation community’s ongoing challenge to stay competitive has numerous friends on the Hill, including senior members of the House Ways and Means Committee.  Legislation introduced by Rep. Clay Shaw (R-FL), H.R. 4421, would dramatically improve the rules governing S corporations.  The bill, entitled “The S Corporation Reform Act of 2005” would:

• Increase access to capital by reducing S corporation ownership restrictions;

• Reduce double taxation of American business by easing transition rules for C corporations that convert to S corporation status;

• Increase S corporation flexibility by allowing multiple classes of stock and convertible debt; and

• Protect S corporations from crippling taxes in the event they inadvertently violate their S Corporation status. 

Consider a family business that became an S corporation back in 1958.  Today, this business has multiple generations of shareholders and multiple challenges, including:

• Transfer of management to the next generation;

• Estate tax planning;

• Attracting new capital investment;

• A possible sale; and

• Competition from the LLC down the road. 

The S Corporation Reform Act helps with each of these unique challenges. 

Improving the S corporation structure is one challenge facing today’s S corporation.  Fighting to preserve the principle of one layer of taxation is another.  Most family business shareholders would be surprised to know that high ranking government officials are advocating unfairly increasing taxes on America’s S corporations, some even going as far as to call S corporations “…a multi-billion dollar tax shelter…”.  The S Corporation Association is aggressively fighting these proposals, working with small business advocates both in Congress and the business community to educate policy makers on why these proposals are bad tax and economic policy. 

As an example, in “Options to Improve Tax Compliance and Reform Tax Expenditures” (JCS-02-05), Congress’ Joint Committee on Taxation proposed a $57 billion tax increase (over 10 years) by applying federal payroll taxes against all S corporation net income, regardless of whether it derives from labor or capital investment.  For small S corporations, this proposal represents a 15 percentage point tax increase, while for larger S corporations, the tax increase would amount to nearly 3 percentage points. 

The Treasury Inspector General for Tax Administration (TIGTA) has since piled on, arguing that all net income from S corporations that are more than 50 percent owned by a single shareholder should be subject to payroll taxes.  TIGTA testified before the Senate Finance Committee that “…the S corporation form of ownership has become a multibillion dollar employment tax shelter for single-owner businesses.”  TIGTA estimates that more than three-quarters (79 percent) of S corporations would see their taxes increase under this proposal. 

Congress created S corporations to encourage family business creation by eliminating the double layer of tax on closely-held corporations.  Congress’ intent was reflected in the IRS Revenue Ruling 59-221 (1959) establishing that S corporations should pay payroll taxes on salaries paid to shareholders only, not S corporation profits.  Today, the IRS enforces this ruling by applying a “reasonable compensation” standard to S corporation owners who actively participate in their business.  Applying payroll taxes to all S corporation income, including income derived from capital investment, is nothing but a backdoor means of reinstating double taxation – exactly the opposite of what Congress intended. 

In response, the S Corporation Association put together a coalition of 41 business groups in Washington, DC to fight these proposal (click here for letter). As our S Corporation Alliance letter states, “subjecting the net earnings of S Corporations to the payroll tax, regardless of whether they are distributed to the owners of the firm or represent return on capital, violates the long-standing principle that payroll taxes be applied to wage income.” 

Moreover, massive payroll tax increases are not the only challenge faced by America’s S corporation community.  In 2005, the IRS issued the results of its National Research Project to estimate the so-called “Tax Gap”.  The Tax Gap is defined as the amount of federal tax owed to the IRS, but not paid on a timely basis.  As part of the NPR, the IRS is currently auditing 5000 S corporations over the next three years.  This is the second of five rounds of audits planned under the NRP.  The first round focused on high income individuals, with the focus on those that file as sole proprietorships and farms.  The third, fourth and fifth rounds will focus on C corporations, partnerships, and individuals filing under 1040 respectively. 

The S Corporation Association fully supports better IRS enforcement, but the focus on high income individuals, sole proprietorships and S corporations in the first rounds of audits has created the impression that small businesses are the sole cause of the tax gap.  This impression leads to tax proposals like those put forward by the JCT and TIGTA to unfairly increase the tax burden on S corporations and partnerships. 

The S Corporation Association is working closely with other business groups, members of Congress, and the Administration to ensure that S corporations are not unfairly targeted during the policy debate over the Tax Gap.  Instead, the S Corporation Association echoes the sentiments of Congressman Donald Manzullo, Chairman of the House Small Business Committee, who wrote the IRS Commissioner expressing concerns over the NPR program.  As the Chairman stated, “A more thorough study of taxpayer noncompliance would allow the IRS to better target its limited resources.”  Picking on S corporations will not close the Tax Gap, but it will slow the growth America’s most popular form of business. 

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