An S Corporation is a business that registers with the Internal Revenue Service to obtain special tax benefits. To hold this status, the business must comply with several regulations. Part of these regulations, which are defined by the Internal Revenue Code, restrict who may own stock. If you transfer stock to a person or entity that is prohibited from owning S corporation stock, the business will automatically lose its tax status. As a result, many S-Corps have agreements in place that may limit to whom a shareholder may sell her shares.
Determine if the S-Corp has a valid shareholders’ agreement. A common way for S-Corps to restrict who can purchase their shares is through a shareholders’ agreement. This contract is generally created when the S-Corp forms and is signed by the current shareholders. This agreement will identify to whom you can and cannot sell your shares.
Establish the sale price for the stock. If a shareholders’ agreement is in place, it may define how much you can charge for your shares. If there is no agreement, you will need to determine the value of the business and divide that amount by the number of outstanding shares. There are many different business valuation methods, such as adding up the total value of the business’s assets; determining the current value of all of the business’s future income; or comparing the S-Corp’s value to other businesses that have an established market value. You will probably need to negotiate with your prospective buyer and agree on a valuation method.
Determine if the stock purchaser is permitted to own S-Corp stock. If there is no shareholders’ agreement in place, you will need to check to ensure the buyer can own S-Corp stock. Only individuals who are citizens or resident aliens, certain trusts and estates may own S-Corp stock. Partnerships and corporations may not own S-Corp stock.
Draft a sales agreement. The sales agreement should identify the parties to the transaction, how much stock will be sold and the price per share. In addition, the sales agreement should require the person buying the stock to agree to comply with the S-Corp’s bylaws and shareholder agreements.
Execute the exchange of stock and cash. Both you and the buyer should sign the agreement. Keep a copy of the agreement with your tax documents for the year.
Request a final K-1, which is the form a corporation sends shareholders disclosing their share of the company's income for the year. As a former shareholder, you are still responsible for including your share of the S-Corp’s income and losses on your personal tax return for the period of time when you owned the stock. The S-Corp is responsible for providing you with a copy of your final K-1 detailing that information. Check to make sure the “Final K-1” box is checked on the form.
References & Resources
- Internal Revenue Service: S Corporations
- Internal Revenue Service: Instructions for Form 1120S – Income Tax Return for an S Corporation
- Business Dictionary: Shareholders’ Agreement
- Duhaime.org: Shareholder Agreement Definition
- Family Law Source: Business Valuation
- Business Dictionary: Purchase Agreement
- Internal Revenue Service: Instructions for 1120S K-1