How to Remove a Shareholder from an S Corp.

By Laura Payet

How to Remove a Shareholder from an S Corp.

By Laura Payet

An S corporation, or S corp., differs from a traditional C corporation, or C corp., in the way corporate income is taxed. While a C corp. pays taxes at the business level on its income, an S corporation's income passes through to its shareholders who then pay taxes on their share of that income via their personal income tax returns. To remove a shareholder from an S corporation, follow these steps and adhere to any specific requirements in your shareholder agreement and bylaws—these documents govern the operations of the organization.

1. Consult the shareholder agreement and bylaws.

To qualify as an S corporation, a business may have no more than 100 shareholders, and those individuals must satisfy strict Internal Revenue Service eligibility requirements. When a shareholder no longer meets these requirements, the organization must remove her or lose its S corp. status. Because of these regulations, most S corp. bylaws contain provisions detailing how to remove a shareholder when necessary. The bylaws should include whether the board of directors or the shareholders must vote on the removal and how to value the shareholder's shares so that the business can buy those shares back.

If neither the shareholder agreement nor the bylaws provide a mechanism to remove shareholders, your state's corporation law controls the process. If this is your situation, you may want to consult with an experienced attorney to ensure your organization takes the appropriate steps in accordance with the relevant state statutes.

2. Obtain approval from the directors or shareholders.

Generally, bylaws require the board of directors or the shareholders as a whole to meet and vote on a resolution to remove a shareholder. The resolution does not have to follow a specific format unless the bylaws say otherwise. It should, however, contain the date of the meeting at which the vote was taken, a statement resolving that the shareholder be removed, and a provision that the business purchase the departing shareholder's shares. Once the resolution is ready, call a meeting of the necessary parties and vote. If a majority approves the resolution, have the corporate secretary sign it. Record the vote in the meeting minutes and keep the minutes and the resolution with the corporate records.

3. Buy back the departing shareholder's shares.

Assuming the resolution passes, the next step is for the organization or the remaining shareholders to buy back the departing shareholder's interest in the business. Because S corp. shares are not publicly traded, there is no obvious market price for those shares. Again, look to the bylaws or shareholder agreement for how to value shares in the event of a buyout. If these documents are silent on this issue, you may need to hire an expert to ascertain the shares' fair market value.

After attaining a proper value of the shares, prepare and execute a purchase and sale agreement between the S corp. (or the remaining shareholders if they are purchasing the shares) and the departing shareholder that includes the sales price and valuation method. We offer example forms for agreements like this and assistance in completing them. Keep this agreement with the corporate records.

4. Update the corporate records.

After accomplishing these steps, update the corporate register and any other relevant corporate records to indicate that the former shareholder is no longer part of the business. Adjust the remaining shareholders' capital accounts to properly reflect their amended ownership interest. Remember to issue a final Shareholder's Share of Income, Deductions, Credits, etc. (Form 1120S, Schedule K-1) to the former shareholder accurately reporting her share of corporate profits and losses during the time she was a shareholder.

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