An S corporation begins its life as a regular corporation. At some point after creation, the corporation makes a Subchapter S election with the Internal Revenue Service for special tax treatment. To be approved, the corporation must meet the IRS eligibility requirements. S corporations remain subject to the laws of the state as they apply to all corporations, including laws on transfers of ownership. If the change in ownership destroys its IRS eligibility, the corporation will automatically lose its S corporation status.
Transferability of Shares
Ownership of a corporation is held by the shareholders in the form of stock. This is true for both regular corporations and S Corporations. Generally, a shareholder has an unrestricted right to sell or transfer his shares to another person or entity, which has the effect of switching corporate ownership in proportion to the number of shares purchased. This freedom may be limited by specific provisions contained in the corporate bylaws. The bylaws represent the rules and procedures for how the company conducts its operations.
S corporations avoid the double taxation feature of regular corporations. The S corporation does not pay income tax on its earnings, which "pass through" to the shareholders to be reported on their individual tax returns. However, not all corporations meet IRS eligibility. To qualify, the corporation must have 100 shareholders or fewer, the shareholders must be individuals and not other business entities, and the company can issue only one class of stock.
Due to the strict IRS requirements, S corporations may include stock transfer restrictions to guard against losing the beneficial tax treatment after ownership switches hands. This can be accomplished by including provisions in the corporate bylaws, through individual agreements between the shareholders, or through agreements between the corporation and the shareholders.
Examples of restrictions to stock transfers include requiring shareholders to sell the stock back to the corporation first, requiring advance approval from the corporation for any transfers to a third party, and forbidding transfers to any business entities. This can prevent sales to multiple individuals that might push the corporation over the 100-shareholder limit and destroy its S corporation status. Further, limiting transfers to individuals prevents the S corporation from losing its status for having stock owned by partnerships, limited liability companies or other corporations.
Finalizing the Switch
Provided that the change in ownership does not affect the corporation's ability to maintain its Subchapter S status, a few additional steps are required to complete the transfer. First, you must set a value on the ownership interest to be transferred by negotiating a stock price with the buyer. Once the price is set, you may then execute a written stock transfer agreement, which becomes an enforceable sales contract. Finally, the corporation must record the transfer in its corporate stock ledger. The stock ledger contains chronological journal entries for every transaction made involving stock in the company.