While an S corporation functions like a C corporation, it is taxed differently. Each shareholder pays taxes on his share of the corporation’s income annually and has a capital account. So when a shareholder decides to surrender his ownership, the S-corp must ensures that all of the departing shareholder’s benefits are properly paid and ensure that he pays tax on his share of the corporation’s income during the period he owned S-corp.
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Balance the shareholder’s capital account. The shareholder’s capital account is a measure of each shareholder’s investment in the business. A person’s capital account increases when she invests her money in the business or the business makes money and does not distribute the shareholder’s portion of the profits. The capital account decreases if the business sustains a loss or pays a dividend to the shareholders. Pay the exiting shareholder his capital balance if it is positive; demand payment equaling the capital account balance if it is negative.
Establish a value for the shareholder’s stock. Evaluating the value of an S-corp’s stock can be difficult because it is a small company that is not publicly traded. Due to IRS restrictions regarding who may own S-corp stock, your business may have a buyout agreement which compels it to buyback any shares from departing members at a price it establishes. If there is no buyout agreement or it does not establish a buyback price, you can determine in a number of other ways including dividing the value of all the business’s assets and dividing that by the number of outstanding shares. You could also estimate your company’s share price based on other publicly traded companies’ stock.
Buy back the shareholder’s stock. Exchange the agreed upon price for the shares of the departing member. Prepare a valid contract executing the sale. Identify the parties: the seller and the S-Corp. List the consideration, or assets being exchanged; the stock for the purchasing price. Have the departing member and a corporate officer sign the document as evidence of both of their consent to the agreement.
Update the corporate stock register and capital accounts. Signify in the stock register that the departed shareholder is no longer part of the company. Please note that for financial reporting debits decrease equity accounts and credits decrease asset accounts. Credit the asset cash account by the amount of money paid to reacquire the shares. Debit outstanding common stock by the number of shares repurchased multiplied by its par value. Debit retained earnings by the amount you paid to reacquire the stock minus the amount you debited to common stock.
Issue the shareholder a final K-1. The K-1 is a report issued by the corporation informing each shareholder how much of the business’s income and losses they need to include on their personal returns. Check the box in the top right hand corner of the form labeled “Final K-1.” In the appropriate boxes, record the departing stockholder’s share of income and revenue from the beginning of the corporation’s tax year to the day the when the corporation bought back the shares.
Tips & Warnings
- Consider using an online document provider to help prepare the necessary paperwork to remove the shareholder.
References & Resources
- Internal Revenue Service: S Corporations
- Real Life Accounting for Non-Accountants: Theme: Understanding Equity Accounts
- Business Dictionary: Shareholders’ Agreement
- Duhaime.org: Shareholder Agreement Definition
- Family Law Source: Business Valuation
- Entrepreneur: Is this Contract Valid?
- Accounting Coach: Explanation of the Topic – Debits and Credits
- Tidewater Community College: ACC 212 – Handout O2 Corporations
- Internal Revenue Service: Instructions for 1120S K-1
- Internal Revenue Service: 1120S K-1