S corporations are corporations that have made a special election with the Internal Revenue Service to be taxed only at the individual shareholder level rather than at both the corporate and individual levels. Owners of the company, known as shareholders, do not participate directly in business operations and may not be voted out. If a shareholder takes on an additional function as a director or officer, he may be removed from that position. However, this removal does not affect the shareholder's ownership in the company.
Overview of S Corporations
Corporations are formed under state law and, by default, are federally taxed at both the corporate level and at the individual shareholder level. However, corporations with fewer than 100 shareholders and several other characteristics may qualify to be taxed only at the shareholder level by the IRS. Corporations that choose this option are known as S corporations, and aside from the preferential tax treatment, must still comply with the same state law requirements as traditional corporations.
Stockholders in an S corporation have the power to elect members to the board of directors. The directors have control over the major financial and strategic decisions of the company, and ensure compliance with the law. The board also has the power to hire officers who are responsible for the day-to-day affairs of the company, such as a president and secretary. While stockholders do have indirect control over the company by determining the composition of the board, they do not directly participate in making management decisions.
Shareholder as Board Member
If a shareholder is elected to the board of directors in any S corporation, she may be removed from the board by the shareholders. The number of votes required depends on the terms of the bylaws, but removal is often by majority vote. It is important to note that although a board member may be voted out, this act does not change her ownership in the company. Shareholders retain their ownership interest unless it is transferred. Some states have passed legislation dealing with the rights of minority shareholders to avoid oppression by the majority. Delaware, for example, allows minority shareholders to bring a direct claim against the controlling shareholders if the minority shareholders are forced to sell their stocks below market value or the controlling shareholders are issued more stock at an unfair price.
Due to IRS guidelines, an S corporation is limited in size. For this reason, many S corporations are also close corporations, which are often restricted by state law to 35 to 50 shareholders. Close corporations are exempted from some corporate formalities and may operate under the terms of a shareholders' agreement. This provides for flexibility in management and allows shareholders to run the company in place of a board of directors. However, it is important to remember that shareholders may not be voted out despite having more authority in a close corporation.