How to Record an S Corporation Stock Sale

By Tom Speranza, J.D.

How to Record an S Corporation Stock Sale

By Tom Speranza, J.D.

An S corporation is a domestic corporation that has elected to be taxed as a partnership by filing Election by a Small Business Corporation (Form 2553) with the Internal Revenue Service (IRS). An S election enables a corporation to avoid the double taxation that occurs when a company is taxed as a corporation. This means that an S corporation does not pay federal income tax as a separate entity but instead allocates its income to the shareholders, who include it in their individual tax returns.

Two people shuffling through many papers on desk

If an S corporation wishes to sell additional shares of stock to a new or existing shareholder, or if an existing shareholder wants to sell shares to a third party, the company should take the following steps.

1. Confirm the new shareholder's eligibility.

S corporations must comply with strict federal limitations imposed on their capital structure and shareholder types. Any proposed issuances or transfers of stock should be reviewed to avoid violation of the following guidelines:

  • The corporation cannot have more than 100 shareholders.
  • All shareholders must be individuals, estates, certain kinds of trusts, or entities that are exempt from federal income tax under Sections 401(a) or 501(c)(3) of the U.S. Tax Code.
  • No shareholder can be a nonresident alien.
  • The corporation can have just one class of stock.

Violation of these requirements can invalidate the company's S election.

2. Check for transfer restrictions.

Closely held companies typically impose transfer restrictions on their stock, primarily because the shareholders of a small business want to retain control over the admission of additional owners. In an S corporation, there is the added worry that an unrestricted right to transfer stock could lead to termination of the S election.

The company should review the following documents for restrictions or conditions on the sale of stock:

  • Articles of incorporation
  • Bylaws
  • Shareholders' agreement

The restrictions can range from certain required votes or approvals by the shareholders or directors to rights of first refusal (in which the company or other shareholders have a right to match the share price to be paid by the third-party buyer) or a requirement that the seller provide a legal opinion that the proposed transfer will not invalidate the S election.

3. Record the sale in the stock transfer ledger.

Once the company is certain that the conditions imposed on the corporation's sale of new shares or a shareholder's sale of existing stock to a third party have been fulfilled, the transaction should be recorded in the company's stock transfer ledger.

A typical transfer ledger requires the following information:

  • Closing date of the sale
  • Seller's name (the company or an existing shareholder)
  • Buyer's name
  • Number of issued or transferred shares
  • Purchase price per share and total purchase price
  • Buyer's capital contribution, if different from purchase price
  • Existing share certificate numbers, if the sale involves already issued shares
  • New share certificate numbers (new certificates issued in the name of the buyer replace the seller's certificates)

The company should retain in its records a copy of any stock purchase agreement or subscription agreement signed by the relevant parties.

4. Amend shareholders' agreement.

Any new shareholder must join the existing shareholders' agreement by signing either a joinder or amendment to the agreement. The company's lawyer can draft the required documentation.

5. Determine tax treatment for the fiscal year.

If the sale occurs in the middle of the company's fiscal year, the company must select an IRS-approved method of allocating income and loss to the shareholders for the partial fiscal year: either the interim closing method or the proration method. If the company's shareholders' agreement designates an allocation method for this particular scenario, the company should follow the agreement's guidance.

In general, S corporations follow the same procedures as regular corporations when they issue new shares or permit existing shareholders to sell shares. But with a valuable S election to preserve, S corporations must carefully follow the steps required by their formation documents and IRS guidelines. The company's lawyer and accountant can be valuable resources when these transactions arise.

This portion of the site is for informational purposes only. The content is not legal advice. The statements and opinions are the expression of author, not LegalZoom, and have not been evaluated by LegalZoom for accuracy, completeness, or changes in the law.