S corporations have a special tax election with the Internal Revenue Service under Subchapter S of the Internal Revenue Code. This allows S corporations to not pay federal income taxes; instead, they elect to pass their income and losses through to their shareholders who then apply them on their personal income tax returns. The Internal Revenue Service places eligibility restrictions on corporations that want to make this Subchapter S election, particularly restricting the type of shareholders an S corporation can have. As a result, many S corporations include specific provisions in their shareholders agreement to remove shareholders if they become ineligible and permit the S corporation to buy out a shareholder voluntarily or involuntarily.
Follow Shareholders Agreement and Bylaws
Check the shareholders agreement of the S corporation for the general procedures or recommendations for removing a shareholder. Although shareholders agreements vary from organization to organization, these provisions should provide directions for the buyout of shares and the approval that is necessary to remove a shareholder.
Determine whether the shareholders agreement addresses the issue of removing a shareholder. If it does not, the default provisions of the state's corporations statute apply, as each state has enacted different laws covering this process.
Determine if the shareholder removal is voluntary or involuntary. If the shareholder's removal is involuntary, there likely must be a violation of the bylaws, as the bylaws control.
Create a Resolution
Create a resolution for the removal of the shareholder that will be presented before the governing board – either the board of directors or designated shareholders, depending on the procedures set forth in the shareholders agreement.
Devise the resolution. The resolution does not need to be formatted in any specific format, although it must provide the buyout request and should state the grounds for removal. Ideally, the grounds for removal should be a violation of a provision in the bylaws. For example, becoming an ineligible shareholder under the S corporation eligibility requirements set forth in Subchapter S of the Internal Revenue Code. If the bylaws do not establish grounds for the involuntary removal of a shareholder, he can be removed only if he violates some provision of the state's corporation statute, such as committing fraud against the corporation.
Sign the resolution and obtain the signature of the corporate secretary.
Remove the Shareholder
Call a meeting and present the resolution for a vote of approval before the governing board – the board of directors or designated shareholders, whichever the shareholders agreement determines. Once the required vote is met, obtain the signature of the corporate secretary.
Look to the shareholders agreement for directions on the buyout procedure of the removed shareholder's ownership interest. Buy the shareholder's ownership interest at fair market value and adjust the remaining shareholder capital accounts accordingly. The valuation method used to determine the fair market value of the shareholder's ownership interest should be specified in the buy/sell provisions of the shareholders agreement.
Ensure the shareholder is officially removed from the S corporation when you adjust the shareholder capital accounts.