The History and Challenges of America’s Dominant Business Structure

Before Congress created S corporations, entrepreneurs had two 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 choose a partnership or sole proprietorship, 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.

A few years later, Republican President Dwight Eisenhower found himself under fire from the Democratic Congress for practicing “trickle-down economics” and favoring big corporate interests over the little guy.

At the same time, Republicans and Democrats were increasingly alarmed that too much economic power was being consolidated into the hands of a few wealthy, multinational corporations. This economic centralization was characterized by economists like John Kenneth Galbraith, who saw America’s economic future as a grand balance of power between Big Labor, Big Business, and Big Government. Private enterprise was viewed as a thing of the past.

In response to these concerns, Eisenhower embraced the Treasury proposal and recommended the creation of the small business corporation to Congress. In 1958, led by Democratic Finance Chairman Harry Byrd, Congress acted on Eisenhower’s recommendation, creating subchapter S of the tax code as part of a larger package of miscellaneous tax items. 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. Reducing an oppressive level of tax was an essential part of the legislation. As the Finance Committee noted at the time of passage, “permitting shareholders to report their proportionate share of the corporate income, in lieu of a corporate tax, will be a substantial aid to small business.”

Nearly a half century later, S corporations are the most popular corporate structure in America. The IRS estimates that there were 4.5 million S corporation owners in the United States in 2007 – about twice the number of C corporations.

And the popularity of S corporations has accelerated over the years. In just the last 10 years, the number of S corporations has grown from 2.7 to 4.5 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.

Modernizing the S Corporation Structure and Current Challenges

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.

The S corporation community’s ongoing challenge to stay competitive has numerous friends on the Hill, including members of the House Ways and Means Committee and the Senate Finance Committee. Legislation to dramatically improve the rules governing S corporations has been introduced in previous sessions of Congress. This legislation focused on modernizing the rules that apply to firms that have selected S corporation status to ensure they continue to be competitive in the next fifty years.

The S corporation is also at the center of two of today’s most critical economic debates. First, the tax rates S corporation shareholders pay are under considerable upward pressure; they are scheduled to go up significantly at the end of 2010 and there are numerous credible proposals to raise them even further. Second, the failure of wages to rise significantly during the recent expansion is magnifying concerns that wealthy Americans are getting richer at the expense of the middle class.

The basic structure of the S corporation places them in the bulls-eye of both these debates. The key aspect of all “flow-through” businesses (S corporations, partnerships, and sole proprietorships) is their business income flows through to the shareholder, who then pays tax on that income at the individual tax rates. Proposals to raise taxes on upper-income Americans will hit more than a million of these businesses.

Moreover, as Congress reduced the top tax rate from 91 percent to today’s more humane 35 percent, business income migrated from the corporate to individual tax codes. Today, most business income is taxed on the individual code, skewing distribution tables and inflating the annual incomes of business owners.

Proposals to address this perceived wealth gap by raising tax rates have the potential to reverse the fifty year trend of empowering privately-held enterprises. They will benefit Home Depot and hurt the locally-owned lumber yard.

So who gets hurt? Workers for starters. Most new jobs are created by small businesses, and most small businesses are organized as S corporations, partnerships, and sole proprietorships. The Census Bureau estimates there are more than 6 million employers in this country, but there are only 2 million C corporations. Do the math — flow-through businesses like S corporations are responsible for creating a lot of jobs.

Local communities are also at risk, as the businesses that comprise their economic and social foundation see their taxes go up and their viability go down.

Over the past fifty years, policies embraced by Democratic and Republican Congress’ alike have made the S corporation rules more flexible while reducing the marginal tax rates these businesses pay. In return, S corporations have made the American economy more flexible, dynamic, and diverse, helping to create much needed jobs while providing an essential anchor to communities around the country.

As the only business association in Washington, D.C. dedicated to promoting and protecting the interests of America’s 4.5 million S corporations, the S Corporation Association (S-CORP) is a powerful voice in Washington. Since our creation in 1996, S-CORP has scored numerous legislative victories as it acts as the “eyes and ears” for the America’s S-Corp community. We remain fully committed to our mission to protect America’s family and closely-held businesses from excessive taxes and government mandates while working to ensure America’s most popular corporate structure remains competitive in the Twenty-First Century.