An S corporation is a regular corporation that has made a special election with the Internal Revenue Service to pay taxes as if it was not a corporation. Although S corporations have special tax status, they operate like other corporations in many ways since they are still legally a regular corporation under state laws. Thus, changing ownership in an S corporation requires transferring stock in the corporation.
Not all corporations qualify as S corporations under IRS rules. For example, S corporations cannot have more than 100 shareholders, and none of the shareholders can be a partnership or other corporation. Thus, when you change the ownership in your S corporation, you must transfer shares to a permitted type of shareholder, such as an individual, an estate or certain types of trusts. You can transfer ownership to other types of shareholders; however, your business will lose its special S corporation status. To prevent this type of disqualification, many S corporations include terms in the corporation’s bylaws that restrict who can receive corporate stock. For example, the bylaws could state that stock cannot be transferred to another corporation. Thus, one of the first steps in changing ownership is to verify whether the bylaws have any transfer restrictions and seek approval of the ownership change.
Read More: How to Change the Shareholders' Percentage in an S-Corporation
Before you can transfer ownership, you must know how much the shares are worth. For example, if you own 51 percent of a company valued at $100,000, your shares are likely worth $51,000. However, valuing shares is rarely this simple since it can be difficult to assign a value to the business, particularly in closely held corporations with few shareholders. For tax purposes, it is important to establish a value for the sale of your shares even when the transfer of ownership is essentially a gift. Your capital gains tax obligations, if any, may be calculated using the value of your shares, and the new owner’s tax basis in his shares is also based on their value at the time of transfer.
You can facilitate the transfer of ownership with a written sales agreement that formalizes your arrangement with the new owner. Your sales agreement may include the purchase price of the shares; your corporation's bylaws may also mandate that your agreement include terms requiring the buyer to conform to existing bylaws and consent to the S corporation election. You can structure your transfer as an outright sale in which the purchaser buys your shares all at once and ownership is transferred immediately. Alternatively, you can create a gradual sale agreement in which the purchaser buys small portions of the business over time, eventually purchasing your entire ownership interest. The gradual sale may be more flexible if your purchaser cannot finance an outright sale.
Ownership transfers often have tax implications, so you may wish to consult a tax professional before the transfer. The corporation must prepare a final Schedule K-1 for you that reflects your share of profits and losses for the portion of the tax year in which you owned shares. If you create a gradual transfer of ownership, you will continue to receive K-1 forms from the corporation throughout your ownership until all of your shares are transferred.