An S-corporation is a flow through tax entity; its shareholders are taxed on their shares of the business’s income and losses, while the business itself does not have to pay income tax. A shareholder’s percentage in any corporation is the amount of shares she owns divided by the total number of shares outstanding. Therefore, to change a shareholders’ percentage, you must adjust how many shares the shareholder controls, or adjust the amount of outstanding stock.
The methods of changing the shareholders’ percentage in an S-corporation are limited by the restrictions imposed on these business entities by the federal tax code. To retain its tax status, an S-corporation’s shareholders can only be individuals, trusts and estates; business organization shareholders cannot own shares. An S-corporation can only have 100 or fewer shareholders and one class of stock. These requirements prevent the S-corporation from issuing preferred stock to exchange for common stock; the shareholders cannot create a corporation to consolidate their shares under the supervision of one person. Further, the business cannot issue an IPO, or initial public offering, and expand the pool of investors. Each strategy would change the shareholders’ percentage, but would violate the tax code.
Trade Shares between Shareholders
One way for an individual shareholder to change her ownership percentage in an S-corporation is to buy shares from, or sell shares to, other shareholders. Since the S-corporation can only have at 100 shareholders, the pool of available trade partners is limited. This can be an advantage, as the number of transactions necessary to effect a significant change in ownership percentage is low. Since ownership is so concentrated, there are few options for an individual to acquire an S-corporation’s stock. This could also be a disadvantage since the shareholders may not be willing to sell or may demand high compensation for their shares.
Treasury stock are shares that were issued by the corporation, but repurchased by the business. A corporation may buy and sell these shares for multiple reasons, such as to increase the per share value of the outstanding stock or to give the S-corporation resources to meet its stock option requirements. The re-acquisition of stock by the corporation or the sale of treasury stock could alter an individual shareholder’s stake in the business as well as the total outstanding stock. By selling shares to a shareholder, the S-corporation would increase the outstanding shares while expanding the amount of shares the shareholder has. By buying shares from a shareholder, the S-corporation would decrease the outstanding shares while decreasing the shareholder's individual shares.
Read More: Can an S Corp Have Treasury Stock?
Fiduciary Duty of the Board
The process for the reacquisition or sale of treasury stock is generally established in the bylaws, which are the rules the corporation follows when conducting its business. Under the bylaws, treasury stock transactions either need to be approved by a vote of the shareholders or board of directors. The board owes the shareholders a fiduciary duty when executing its responsibilities. The board must act to promote the shareholders’ best interests; it cannot use its position to enrich the directors.
Fiduciary Duty and Treasury Stock Transactions
The fiduciary responsibilities of the board may prohibit it from structuring a treasury stock transaction that benefits a select group of shareholders. The board may be partially composed of “inside directors,” or current corporate shareholders and management. As a result, there may be a presumption that a treasury stock transaction structured to benefit a specific group of shareholders is meant to benefit individual directors. This would be considered a breach of duty, and would leave the S-corporation and board open to a lawsuit.
- Internal Revenue Service: S Corporations
- United States Securities and Exchange Commission: Schedule 13D
- USlegal: Treasury Stock Law & Legal Definition
- USlegal: C-Corporations Law & Legal Definition
- USlegal: Definition of Bylaws
- USlegal: Board of Directors Law & Legal Definition
- FreeDictionary: Inside Director
- Mesriani Law Group: Shareholder Derivative Suits
John Cromwell specializes in financial, legal and small business issues. Cromwell holds a bachelor's and master's degree in accounting, as well as a Juris Doctor. He is currently a co-founder of two businesses.