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.
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.
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.
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.
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.
References & Resources
- Internal Revenue Service: S Corporations
- Dividend Monk: Share Repurchases: An Overview
- Business Dictionary: Shareholders’ Agreement
- Duhaime.org: Shareholder Agreement Definition
- Internal Revenue Service: Instructions for 1120S K-1
- Accounting Coach: Explanation of the Topic Stockholders’ Equity
- Internal Revenue Service: 1120S K-1