Why Limit the Number of S Corporation Shareholders?

By Jim Thomas

The number of shareholder-owners in a Subsection S corporation, commonly known as an S corp, was restricted to 10 when the legislation creating S corps was passed by Congress in 1958. Legislation in 2004 increased the number of shareholder-owners to 100 and enabled family members to be counted as only one shareholder. Congress restricts the number of shareholders because of the nature of an S corp: It is intended to be a way for a family business or small business to obtain the same protection from personal liability that a giant company enjoys, while enabling the S corp shareholder-owners to be free from corporate taxes that larger businesses must pay.

Definition

As the Boston Business Journal explains, an S corp is a corporation that elects to be taxed under Subchapter S of the IRS Code and meets all of the legal requirements of a S corp entity. This includes a restriction on the number of shareholders. A business can organize itself as a limited liability company or a regular corporation, called a C corp, and then request that the IRS designate it as an S corp.

Benefits

Small companies that incorporate as S corps often achieve the best of both worlds. The Small Business Administration notes that an S corp is considered by the IRS to be a unique entity that is separate from the shareholder-owners. That allows the owners to be free from personal liability for the debts and obligations of the business. At the same time, S corps don't have to pay corporate taxes. The profits and losses of the business pass through the S corp and directly to shareholder-owners, who pay only personal taxes.

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Easing Restrictions on Number of Shareholders

Congress has increased the allowable number of shareholder-owners in an S corp since 1958 several times, when it was 10. The number was increased to 35, 75 and most recently, 100. According to the AccountingWeb website, by the end of the 20th century, S corps were the most popular type of corporation. As The CPA Journal reported in 2005, the Subchapter S Revision Act of 1999 aimed to aid small businesses and family-owned businesses by giving them better access to capital and eliminating outdated and onerous regulations.

Business Size

The Marquette Law Review notes that Subchapter S was created by Congress to make it possible for many smaller business to choose a business entity that fit their needs and offered considerable tax breaks. Although the intent was to limit S corps to businesses of relatively small size, the law doesn't spell out specific restrictions in terms of the sales or revenues of the business.

Public Policy Considerations

Is a community-owned bank with $400 million in assets the type of business Congress envisioned in 1958 when it passed legislation creating S corps? It's doubtful, but in subsequent years, community-owned banks such as the $400 million MidSouth National Bank and the small business lobby has effectively persuaded Congress to increase the number of shareholders so that many more businesses now quality for S corp status. Although this is a boost to job-creating small businesses and perhaps the overall economy, it also deprives the government of revenue from larger S corps that wouldn't qualify under older restrictions and would otherwise be required to pay corporate taxes.

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References

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