How to Change Ownership in an S Corporation

By Tom Speranza, J.D.

How to Change Ownership in an S Corporation

By Tom Speranza, J.D.

An S corporation is a domestic corporation that has elected S corporation status by filing the Election by a Small Business Corporation (Form 2553) with the U.S. Internal Revenue Service (IRS). Because individual shareholders are the owners of corporations, the ownership of an S corporation changes when transactions occur involving the company's stock. These can arise in various ways, including issuance of new shares, sale of existing shares, and deaths of shareholders.

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Conditions for S Corporation Status

Under IRS rules, S corporations must be small-business corporations and adhere to the following requirements:

  • The S corporation can have no more than 100 shareholders.
  • All shareholders must be individuals, estates, specific kinds of trusts, and 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 must have only one class of stock.

Careful review is necessary to prevent any proposed change in an S corporation's ownership from violating one of the IRS requirements and therefore terminating the company's S election. For example, a transfer of shares to a for-profit corporation or limited liability company would invalidate the corporation's S election.

Ways That S Corp. Ownership Can Change

State law, IRS guidelines, and the company's articles of incorporation dictate the requirements and processes involved in changes in ownership, which can occur for a number of reasons.

Issuance of New Shares

An S corporation can issue additional shares of stock, either to existing shareholders or to new ones, by following the appropriate procedure:

  1. The S corp. must check its articles of incorporation to determine the total number of authorized shares. The difference between authorized shares and the number of currently issued and outstanding shares represents the maximum number of new shares.
  2. The board of directors must approve a resolution determining a valuation of the company and issuing a stated number of new shares for a stated price.
  3. Upon payment of the purchase price, the company's secretary issues stock certificates to shareholders and records the transactions in the company's stock ledger.

Keep in mind that an S corporation can only have one class of stock; however, an S corp is permitted to issue voting and nonvoting shares that are otherwise identical in the rights granted to the shareholders.

    Sale of Existing Shares

    Shares of stock are personal property that are transferable by the owner—barring any contractual restrictions on transfer, such as a shareholders' agreement. If an S corporation shareholder wishes to sell all or a portion of their stock, the following procedure must be followed:

    1. The buyer and seller must agree on a price per share and sign a stock purchase agreement.
    2. Upon the buyer's payment of the purchase price, the seller transfers the stock to the buyer by signing stock powers that assign the seller's share certificates to the buyer.
    3. The buyer submits the certificates to the company's secretary, who then cancels the seller's share certificates, issues replacement share certificates in the name of the buyer, and records the transactions in the company's stock ledger.

    Death of a Shareholder

    If an S corporation shareholder dies, their stock transfers initially to the shareholder's estate and subsequently to the shareholder's heirs, who inherit the estate's assets following the probate process.

    Although the initial transfer to an estate does not endanger the corporation's S election, the subsequent transfers to heirs can potentially cause problems. For example, an estate with many heirs may cause the corporation to exceed the 100-shareholder limit. Similarly, if a nonresident alien or a for-profit entity inherits S corporation stock, it could invalidate the corporation's S election.

    The most common solution to this problem is to require all shareholders to sign an agreement that completely prohibits any transfer of stock that would terminate the S election (including transfers made pursuant to a will) or gives the company and/or the other shareholders an option to purchase any shares that are subject to a transfer to an ineligible shareholder.

    Once an estate has gone through probate, the new owners of the deceased shareholder's stock submit the share certificates to the company's secretary, who cancels them, issues new certificates in the names of the heirs, and records the transactions in the company's stock ledger.

    Transfers for Estate or Financial Planning

    If an existing S corporation shareholder wishes to transfer stock to a family member, trust, or another entity for purposes of estate or financial planning, the company's tax lawyer or accountant should review the proposed transfers before the company allows them.

    Always Check for Transfer Restrictions

    To protect the S election from invalidation, S corporations often include restrictions on share transfers in their articles of incorporation or in a shareholders' agreement. Be sure to check these documents before completing any stock transaction. There may be notices, opinion letters from lawyers, and other conditions on a stock transfer that shareholders must fulfill before any transfer can legally take effect.

    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.