S Corps have now become one of the most popular business entities, with the number of Subchapter S structures jumping from 725,000 in 1995 to well over 3 million in 2005. But it didn’t use to be this way. Just 71 years ago, S Corporations were just an idea posed by the Treasury. And 59 years ago, Eisenhower was getting ready to sign off on the new entity that gives small businesses greater equality in the marketplace. (This would be a viable Maine secretary of state business entity option, given that the Pine Tree State has roughly 144,002 small businesses.) While the S Corp (1958) is 19 years older than its brother, the popular LLC (1977), it tends to take a backseat. But that doesn’t mean the S Corp is less beneficial nor insignificant. In fact, it’s quite the opposite, where shareholders enjoy pass through taxes and limited liability protection.
In this article, you’ll learn the history behind the S Corp:
- How it started
- How it revolutionized the market
- How it has changed since Eisenhower approved it in the 50s
- What’s good and bad about it
- And why it needs to stay
How the S Corp Began
Before the S Corp, businesses only had the option of forming a sole proprietorship, partnership, or corporation. The problem with this was sole proprietorships and partnerships provided pass through taxes but the owner was liable (for partnerships, at least one owner is liable). However, while your standard C Corporation protected owners from personal liability, owners had to pay double taxation.
For small businesses just starting out and large, thriving corporations, this wasn’t a problem. But where was the business structure that supported small businesses which had passed the launching phase? Because there was no middle ground option at the time, the growing monopolies risked pushing the small businesses out. (Perhaps if the S Corp wasn’t created, we’d be doing business in a market overrun by oligarchs and monopolists?)
To prevent this dreaded reality from happening, in 1946 the Treasury looked into a potential corporation that still contained several corporate benefits but the IRS would treat as a partnership. Eight years later, in 1954, the Senate and President Eisenhower came up with a corporation that met these qualifications. And in 1958, the S Corp was born.
How It Revolutionized the Market
The S Corp made waves in the market because it did what no other business entity had the power to do: bridge sole proprietorships and partnerships with corporations. In a sense, it was one of the first American hybrid structures— possessing pass through powers and limited liability protection. But, more importantly, this business entity gave small businesses tax relief and prevented a potential centralized economy from forming. That and it encouraged people, who may have been hesitant to start a business prior to the S Corp creation, to take the plunge. For all we know, our American entrepreneurship culture today probably wouldn’t be thriving if the S Corp wasn’t around.
How It Has Changed
Since the S Corp originated in 1958, several changes have been made, two of which are the number of shareholders and who can be a shareholder. When it was first enacted, Subchapter S corporations were only allowed to have 10 or fewer shareholders. That number eventually increased. In 1996, it became 35 or fewer. Now, in 2017, it has become 100 or fewer. If this pattern continues, there could be as many as 200-250 shareholders within the next 50 years or so. (With this kind of increase, S Corps may slowly be going the corporate route, as C corps can have an unlimited number of shareholders.)
Other than the increasing number of shareholders, besides estates, individuals and some trusts, family members can now be shareholders. To some, merging family and business could be seen as a red flag—(possible nepotism?). If anything, according to the CBS News, mixing family and business could spell out collateral damage.
S Corporations: The Good and The Bad
S Corps were intentionally created to keep small businesses afloat, providing tax relief in the form of taxing the shareholder’s personal salary but giving a pass on dividend distributions. As we’ve mentioned, this isn’t the case with regular C Corporations, where the earnings and dividends are both taxed.
Normally, S Corp owners will pay themselves a normal salary, with a smaller percentage of dividends cast aside. This percentage should be no higher than 40%, as an Investopedia article mentions. If the dividend percentage passes that 40% mark, business gets shady. The reality is, S Corp owners and shareholders have tried—and some do try—to avoid wage taxes, paying themselves a smaller salary, higher dividend ratio.
(In case you want to know, C Corporation owners and shareholder have done (and do) the same thing, except they increase their salaries and decrease the dividend percentage to get the best (questionable?) tax break.)
Also, many have argued that S Corps, while keeping small businesses up and running, limit their growth. Because, let’s face it, not just anyone can invest into an S Corp business. Specifically, venture capitalists, other entities, and more than 100 shareholders can’t dole out checks to S Corp owners, even in times of financial hardship. (C corporations are a lot more flexible in this regard—making it faster and easier to scale.) So, should an S Corp get into financial trouble, the owner may have to reach into his or her own purse strings, putting money back into the company.
Why S Corps Need to Stay
It’s important that S Corps stay to bridge the gap between partnerships and sole proprietorships with corporations. But the rules and regulations that apply to S corps need to be changed so S corps can still do what they were intended to do—help small businesses. This means increasing the number of shareholders to make fast scalability doable.
Potential Maine Secretary of State Business Entity?
S Corps could be a viable option in states such as Arizona and Texas, which saw a 520-per-100,000-adults startup ratio in 2011 (Arizona) and 440 per 100,000 adult ratio in Texas. No matter what state owners decide to register their S Corp in, it’s important they conduct research to ensure they meet all state regulations. To get started with this research, you can access Sec State, a user-friendly secretary of state database.