Accounting for an S Corporation Shareholder Buyout

By John Cromwell

An S Corporation is a small business that generally protects its 100 or fewer shareholders from the business’s liabilities. Unlike most corporations, the business income is divided amongst the shareholder to include on their personal returns. This allows the business to avoid “double taxation.” To obtain this benefit, the business must conform to IRS imposed restrictions that limit who can own shares in the corporation. As a result of these restrictions, many of these businesses have established rules regarding when and how a corporation can buy out a shareholder, which ultimately defines how the corporation accounts for that transaction.

An S Corporation is a small business that generally protects its 100 or fewer shareholders from the business’s liabilities. Unlike most corporations, the business income is divided amongst the shareholder to include on their personal returns. This allows the business to avoid “double taxation.” To obtain this benefit, the business must conform to IRS imposed restrictions that limit who can own shares in the corporation. As a result of these restrictions, many of these businesses have established rules regarding when and how a corporation can buy out a shareholder, which ultimately defines how the corporation accounts for that transaction.

Shareholder Buyout Explained

A shareholder buyout involves a corporation buying all of its stock back from a single or group of shareholders at an agreed upon price. The corporation will negotiate a price, and then exchange cash for the shareholder’s stock. An S Corporation may buy out a shareholder for a few reasons. If a shareholder chooses to sell his shares, an S Corporation may purchase the stock to protect its business’s tax status. Depending on agreements made by the business owners, the business may also be able to force a buyout if a shareholder takes certain actions. A shareholder buyout can also help a business’s current business metrics, such as return on capital.

Ready to incorporate your business? Get Started Now

Buyout Problems

There are two significant hurdles in executing a shareholder buyout. The first is getting the shareholder to agree to sell his shares to the business. Even if the shareholder wants to exit the business, he may think he could get a better price for his stock if he sold to a third party. Second, since an S corporation is privately held and has few shareholders, determining what the price per share of the departing shareholder may be difficult.

Buyout Agreements

To mitigate the possibility of problems when executing a shareholder buyout, most corporations have shareholder agreements. Generally, these agreements are drafted when the business forms and is binding on all shareholders. A well-drafted shareholder agreement will contain a buyout clause which will require that the shareholder sell their shares back to the company in most situations. It will also define what the price per share would be in the case of a buyout.

Final K-1

Once the buyout is executed, the S Corporation will need to issue the departing shareholder his last K-1 and submit a copy of that form to the IRS. A K-1 is a report that details how much of the S Corporation’s revenues and losses a shareholder needs to include on his personal return. At the top right corner of the form, the corporation must mark the box for Final K-1. The K-1 should cover the shareholder’s portion of the business’s financial activity for the period, starting at the beginning of the business’s tax year to the day he sold his shares.

Financial Records

Shares reacquired by a business are known as treasury stock. These types of transactions are recorded solely on the S Corporation’s balance sheet. The transaction will result in the cash account being decreased, or debited, by the amount of the repurchase price. The cash account is in the asset section of the balance sheet. To balance the cash account deduction, the S Corporation creates a “treasury stock” account in the equity section of the balance sheet. The S Corporation will then increase that account, or credit it, by the amount of the stock reacquisition price.

Ready to incorporate your business? Get Started Now
How to Remove a Shareholder From an S-corp

References

Resources

Related articles

Wills & Shareholder Agreements

Privately-held companies may have restrictions in their shareholder agreements regarding the transfer of company shares to others. This includes the transfer of stock by a recently deceased shareholder through his will. How these agreements influence the distribution of stock through a will to a beneficiary depends on the content of the specific agreement. Please note that laws governing the distribution of property vary by state. Consider hiring a professional to help you interpret your state’s probate laws and the relevant shareholder agreement.

How to Change the Shareholders' Percentage in an S-Corporation

An S-corporation is a flow through tax entity; its shareholders are taxed on their shares of the business’s income and losses, while the business itself does not have to pay income tax. A shareholder’s percentage in any corporation is the amount of shares she owns divided by the total number of shares outstanding. Therefore, to change a shareholders’ percentage, you must adjust how many shares the shareholder controls, or adjust the amount of outstanding stock.

How to Prepare a Final K-1 for an S Corp

An S corporation is a special type of corporation that has elected to be taxed as a pass-through entity. Instead of paying income taxes itself, an S corporation passes profits and losses through to its shareholders. The shareholders pay taxes at the individual rate on their proportionate share of profits and losses by recording the amount on their personal income tax returns. Every year, an S corporation files an information tax return with the IRS, reporting the financial status of the company. Part of the information return is the preparation of Schedule K-1, which details each shareholder's pro-rated share of income or loss from the company. The S corporation sends each shareholder his copy of the K-1 annually, so the shareholder can use it to prepare his personal income tax return. When an S corporation goes out of business, or when it terminates its special tax election, it must prepare a final tax return and a K-1 that details the final allocation of profits and losses to shareholders under this method of accounting.

LLCs, Corporations, Patents, Attorney Help

Related articles

How to Record an S Corporation Stock Sale

An S corporation is a business with 100 or fewer shareholders that has the liability protection of a corporation but is ...

How to Sell S Corp Shares to a Major Shareholder

An S Corporation is a small business of 100 or fewer shareholders where, unlike normal corporations, the business ...

The Basis in an S Corporation

S corporations are businesses with 100 or fewer shareholders that can elect to be taxed as a partnership. The benefit ...

How to Transfer Stock in My S Corporation

An S Corporation is a business that registers with the Internal Revenue Service to obtain special tax benefits. To hold ...

Browse by category