One of the first decisions entrepreneurs make when they decide to start a company is to choose a legal structure for their new business. The most popular options include organizing a partnership, corporation, Limited Liability Company (“LLC”) or a simple sole proprietorship.
One big chapter of my book, Start On Purpose, details the pros and cons of each business entity so startup entrepreneurs don’t make mistakes and have to spend precious time and funds to make adjustments. It’s important for business owners get this decision right from the start.
Now a tax-hungry Congress wants to quietly change the rules of the game for over 4.4 million small business owners and their shareholders. Their target is S-corporation business owners.
So why are S-corporations under attack?
Business owners who operate corporate business structures can opt to “pass-through” most business profits or losses to individual shareholders on a pro-rata basis. In simplified terms, this means that S-corporation shareholders report their share of business profits or losses on their personal tax return.
In contrast, owners of standard C-corporations pay taxes first at the corporate level and then again at the personal level from wages, bonuses or stock dividends.
With the exception of taxes on certain capital gains and passive income, the upshot is that S-corporation shareholders get to enjoy many of the same tax-saving benefits as sole proprietors, partnerships, and LLC shareholders, but still operate a business entity that is flexible enough to accommodate the changing needs of a growing corporate enterprise.
In general terms, the S-corporation tax election also makes it possible for shareholders who work in the corporation (usually the founders) to differentiate between salary-based income and cash distributions based on the pro-rata ownership of business profits. The difference is important. Entrepreneurs are not obligated to pay payroll taxes on dividend-like cash distributions, just salary-based compensation. This is what some leading members of Congress want to change. Your local accountant can provide more detailed information about the fine points of S-corporation tax obligations.
It’s my view that Congress should leave S-corporations alone. Quite simply, it’s the wrong time and the wrong target audience. Here’s why.
1. S-corporations are really small businesses. S-corporations are not at all in the same league as multi-national Fortune 1000 corporations. Because S-corporations can’t have more than 100 shareholders they are almost always privately-held small businesses. S-corporations can’t have foreign or corporate shareholders, which further reduces the scope of typical S-corporation business interests.
2. IRS already monitors S-corporation compliance. Today, S-corporation shareholders who receive salary-based compensation must pay payroll taxes on a “market rate salary.” If Congress really thinks S-corporation shareholders are not paying a market rate salary, then allocate more funds to IRS enforcement. Don’t penalize all other S-corporation shareholders with greater annual administrative obligations and higher tax obligations because of a few greedy S-corporation operators who don’t pay themselves a minimum market rate salary.
3. Discourage business investment. What Congress doesn’t appreciate is most small companies are initially funded by one or more founding business partners. They take funds out of personal savings and invest at the riskiest time in a company’s history—before a business has any products, customers, or profits. Like other investors in small businesses, all S-corporation shareholders are entitled to receive a favorable return on their invested capital that is not subject to over-reaching payroll taxes.
4. Fast-growing S-corps usually become C-corps. As an S-corporation grows, it is likely to convert to a standard C-corporation and fall under existing corporate tax rates. And because S-corporations can’t issue more than one class of stock, ambitious entrepreneurs who want to raise capital from preferred stock-loving angel investment clubs, venture capital funds and expansion-stage private equity funds just elect to be taxed as a standard C-corporation. Problem solved.
At a time when the U.S. economy is dependent on the startups and small businesses for sustainable job growth, it is unacceptable for Congress to add to the paperwork load and make it harder for small business owners to prosper.
In 2012, S-corporations represented about 45 percent of corporate and partnership business returns filed with the IRS. Now is the time for America’s 4.4 million S-corporation founders and their shareholders to speak up before Congress tinkers with a good thing.
The power brokers on this issue are members of the Senate Finance Committee and House Ways and Means Committee. Also, reach out to members of the U.S. Senate Small Business and Entrepreneurship Committee and the U.S. House Small Business Committee.
Susan Schreter is a veteran of the venture finance community and entrepreneurship educator. She is the author of the comprehensive new book, Start On Purpose which provides specific action steps to start a new business, attract investors, and make any new business idea bigger, better and more profitable. Follow Susan @StartOnPurpose