Accounting for an S Corporation Shareholder Buyout

By River Braun, J.D.

Accounting for an S Corporation Shareholder Buyout

By River Braun, J.D.

When an S corporation decides to buy a shareholder's shares of the company, they must follow strict Internal Revenue Service (IRS) regulations to account for this transaction. Failure to do so may result in the company losing its favorable tax treatment.

S corporations are special corporate entities that are limited to 100 shareholders and provide certain tax benefits, like avoiding double taxation. While standard corporations (C corporations) are taxed on profits, an S corporation's income is divided between the shareholders and claimed on their personal income tax statements.

Shareholder Buyouts 101

Put simply, a shareholder buyout occurs when a corporation buys back one or more shareholders' stock. A number of situations might result in a shareholder buyout. Perhaps the shareholders want to depart the company or they have performed specific prohibited actions. Or the company might want to improve its metrics.

Typically, the terms of shareholder buyouts are set down in a shareholder agreement. This is a preventative measure, helping to avoid issues when a buyout occurs. The most common dispute is over the shares' valuation. Due to an S corporation's limited number of shareholders, it can be difficult to price shares. Often, a shareholder feels she can get a more favorable price if she sells to a third party. To prevent these issues, shareholder agreements should include:

  • A buyout clause requiring the shareholder to sell the stock back to the corporation, or at least provide a right-of-first-refusal
  • A definitive price per share or formula for determining it

Shareholder agreements are signed before a business is formed or at the time of initial stock purchase. The agreements are binding on all stockholders.

Shareholder Buyout Accounting Procedures

Upon completion of a buyout, the S corp. issues a final Partner's Share of Income, Deductions, Credits, etc. (Form 1065, Schedule K-1) to the exiting shareholder. The K-1 lists the company's losses and revenues that the exiting shareholder must include in his personal tax return. The K-1 only shows the exiting shareholder's share of the corporation's financial activity for the current fiscal year. This report ends on the date that the shareholder sold his shares. The company should ensure that the “Final K-1" box is checked in the upper right corner of the form to avoid tax issues in the future. When the buyout occurs, the stock basis is updated to reflect the changes in the value of the shareholder's investment. The stock basis reflects the value and position of investments attributed to that shareholder during the tax year. The stock basis fluctuates based on:

  • Annual income
  • Changes in distributions
  • Deductions
  • Losses
  • Capital contributions
  • Loans

When the corporation buys back shares, the taxable gain for that transaction is the net of the stock basis. If the stock basis is not updated, the monies paid to the shareholder would be considered taxable. The shares that the corporation repurchased from the shareholder are called “treasury stock" and are recorded on the company's balance sheet. The transaction yields a decrease in the cash account in the amount of the repurchase price. This cash account is found in the asset section of the balance sheet. To counter this transaction and balance the books, the company creates a treasury stock account, which appears in the equity section of the balance sheet. This treasury stock account will increase in the same amount that the cash account decreases. Alternatively, the corporation could choose to retire the shares, in which case, a treasury stock account would not be created. Shareholder buyout transactions can get messy. Having a shareholder agreement in place before starting a business allows for a smoother process.

TEASER: Are you considering a shareholder buyout? Do you know how this transaction can affect your S corporation's bottom line? Read on for the facts on accounting for shareholder buyouts.

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