By Rick Gier

      Congress created the small business corporation (“S-corp”) 50 years ago to help small business owners. Although S-corps provide a number of attractive benefits, many business owners have bypassed S-corps in recent years in favor of limited liability companies. Proposed changes currently before Congress, however, could make the S-corp an even more attractive option for small business owners. These changes could provide a needed boost to the economy by encouraging small business creation.
     
History of the S-Corp
      Prior to 1958, small business owners often operated as sole proprietorships or partnerships, neither of which provides separation between the owners and their company’s legal and financial liabilities. Proprietorships and partnerships are taxed on a flow-through basis, meaning that owners are personally responsible for the income tax due from company profits; the businesses do not separately pay income taxes.

      Small business owners seeking to avoid personal liability for business debts had only one option: the C-corporation. However, this protection came at a price, because a C-corporation pays income tax on company earnings, and then owners pay personal income tax after receiving distribution of any profits.

      Small business owners sought a change and Congress delivered. Through an amendment to the tax law, the S-corp combined the best of both alternatives. S-corps provide the liability protection of the corporation and a version of flow-through tax treatment similar to the proprietorship and partnership structures.

      However, certain restrictions were imposed to limit the benefits of the S-corp to the 1950’s version of the American small business. These restrictions have changed somewhat over the past half-century, as the definition of “small” has grown from 35 shareholders to the current maximum of 100.

      Other restrictions on S-corporations preclude non-resident aliens from owning S-corp shares. This is because the benefits are designed to flow to citizens or individuals who are physically in the United States, and from whom personal income taxes can be easily collected. Further, S-corps may only offer one classification of stock, meaning that all shares of stock have identical rights. Finally, S-corp shareholders must be actual, living, breathing human beings or legal entities that are treated under the law as human beings, such as certain estate planning trusts. These restrictions have made the S-corp unavailable to certain small businesses that could not meet the stipulations.
     
Updating the S-Corp
      Limited liability companies (LLCs) first arrived on the scene in the 1970s. LLCs have become popular legal entities because they offer many of the same benefits as corporations, but are much more flexible and carry no restrictions on ownership. While there is no formal competition between the two entities, many small business owners and their advisors have bypassed S-corps in favor of LLCs in recent years.

      Several proposed legislative changes would broaden the availability of the S-corp to more small businesses by loosening some of the ownership restrictions. One proposal would increase the maximum number of permitted shareholders to 150 when a community bank is involved. Community banks have been permitted to form S-corps since 1997, and are more likely to find themselves bumping up against the current shareholder limits than the “mom and pop” S-corp. An increase in the number of shareholders would make the S-corp a viable option for some larger community banks.

      A second proposal would permit non-resident aliens to own shares in S-corps, allowing companies to take advantage of global investment opportunities. Coupled with this proposal is a mechanism to collect income taxes from non-resident aliens, diminishing the concern about non-collectability that is often cited to support this restriction. This change would represent a significant shift from a focus on “American” small business, to a more global approach.

      A third proposal would remove the restriction on a single classification of stock. By permitting an S-corp to offer preferred stock, it is argued that a larger pool of potential investors could be tapped by a small business. Some investors might only invest if they are given preferential treatment regarding distributions of income. Again, this represents a broader view of how a small business looks in 2008.

      Much has changed in the 50 years since Congress created the S-corp. While Congress has periodically altered the regulations and restrictions on S-corps during that time, the changes currently under consideration could have a significant impact on small business owners. S-corps could become more attractive and more widely available as legal entities of choice for new and existing small businesses.

      It will be worth paying attention to the various modernization and reform acts that are currently being considered in Washington. Be sure to ask your attorney about the status of this legislation when considering a legal entity for your business.

Rick Gier is an attorney and small business owner who serves small business clients in Kansas and Missouri. You can reach him at (913) 239-8902 or , or by visiting www.GierLaw.com.