Switching Ownership of the S Corp

By Wayne Thomas

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.

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.

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S Corporations

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.

Restrictions

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

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.

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How to Change Ownership in an S Corporation

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S Corporation Restrictions

An S corporation offers companies the ability to funnel their earnings and losses directly to the owners, thereby avoid double taxation. In addition, the use of the corporate structure grants the shareholders limited liability. However, the S corp election is very fragile. Making a mistake on just one of the restrictions can cause the company to lose its special status and therefore be taxed as a regular corporation.

Can Living Trusts Own S Corporation Stock?

An S corporation is simply an ordinary corporation chartered under state law whose shareholders have decided to make a special tax election under the Internal Revenue Code. One of the main advantages of forming an S corporation is the avoidance of double taxation. An S corporation's profits and losses are reported only on its shareholders' personal tax returns. The business itself is not required to pay taxes, unlike a typical corporation. Because of these advantages, the Internal Revenue Service has certain limitations regarding the corporations that qualify for S corporation status.

Can an S Corp Have Treasury Stock?

An S corporation is a state registered C corporation with a special tax status granted by the Internal Revenue Service. This means that an S-corp has to comply with the regulations of the state where it is incorporated as well as meet ownership and standards established by the IRS. Treasury stock are shares issued by a corporation that it either repurchased from a shareholder or issued but did not sell. Prior to obtaining treasury stock, an S-corp should evaluate state and IRS regulations to ensure it can hold those types of securities.

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