An S Corporation is a small business of 100 or fewer shareholders where, unlike normal corporations, the business entity itself is not taxed. Each shareholder is taxed on their share of the business’s income on their personal return. Because of this advantage, the IRS places several restrictions on who can be an S Corp shareholder. Failure to meet those standards will result in the business losing its tax status. To ensure that the business does not lose its tax status, many S Corps have transfer restrictions in place regulating when its shares can be transferred.
Review any buy-sell agreements related to the S Corp. A buy-sell agreement, otherwise known as a buyout agreement, governs what happens when a shareholder chooses to leave the business. These documents may be included in the S Corporation’s bylaws or as a separate document. When reading the relevant restriction documents, check to see if you are permitted to sell to pre-existing stockholders. Sometimes the corporation will require you to sell the shares back to it in order to preserve the current ownership balance between the existing shareholders.
Read More: How to Withdraw From S Corporation Ownership
Establish a sales price for the shares. Because S Corps are not publicly traded, determining a per-share price could be difficult. If the S Corp has a buy-sell agreement, it may provide an agreed upon method by the shareholders for determining the value of a share of S Corporation stock. If there is no method contained in the buy-sell agreement, there are other means of determining share price. You could value the assets of the business and divide that amount by the number of outstanding shares. You could calculate the net present value of the income the business is going to earn and divide that amount by the number of outstanding S Corp shares. Or, you could value the business based on the share price of comparable, publicly traded businesses.
Draft a stock purchase agreement. A purchase agreement is a contract between you and the buyer that defines the terms of the stock transaction. The stock purchase agreement should state the per share price of the stock and how many shares you are going to sell. It should identify who you are going to sell the stock to and name yourself as the seller.
Execute the stock purchase agreement. Have both you and the buyer sign the agreement and keep a copy of the records. Hand the buyer the shares and accept the payment for the stock as defined by the purchase agreement.
Notify the S Corp of the transaction. Make sure they record the ownership change in their stock registry and accounting system and that they accurately noting when the transaction took place. It is vital that the S Corporation does this so it may properly prepare your final K-1.
Get your final K-1 from the S Corp after you sell your shares. The final K-1 should provide your share of the business’s income and losses from the period when you still owned the S Corp shares. Include that income on your next tax return.
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.