If you are seeking to purchase a small business organized as an S corporation, there are several state and federal procedures you must follow. In the state where the business is incorporated, you will have to submit documentation to the Secretary of State detailing the changes. For tax purposes, the S corporation needs to close the books and issue K-1s to the old shareholders based on the business’ financial activity up until the sale, and then issue K-1s again at the close of the year to the new shareholders.
S Corporation Basics
An S corporation is a normal corporation with a special tax status. Composed of 100 shareholders or fewer, the S corporation allows stockholders to include their share of the business’s income on their tax return. This means the S corporation’s owners avoid the double taxation characteristic of traditional corporations. S corporations are incorporated under state law, so organization requirements vary. However, the American Bar Association’s Model Business Corporation Act provides an excellent platform to discuss reporting requirements and procedures in general. The MBCA has been adopted by 32 states and provides a theoretical basis that other states have used in developing their own corporate code.
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Mere ownership of a business occurs when a person acquires stock in the S corporation. Control of the business only occurs when a party acquires a majority of the voting shares of stock. Voting majorities are required to select the board of directors, approve share issuances, accept article of incorporation amendments, agree to mergers and significant asset acquisitions, and to dissolve the business. When a new set of stockholders gains control of the business, the board of directors and officers generally will be replaced. In that case, the S corporation will need to name a new registered agent, eliminate the ability of the old board to transact business on the S corporation’s behalf, and possibly amend its articles of incorporation. Each one of these steps requires the new corporate leadership to file a corresponding form with the incorporating state’s Secretary of State. Each form will have a corresponding fee. If you acquire an S corporation, you will need to contact the Secretary of State or review its website to obtain the appropriate forms.
S corporations are taxed by having the owners include their share of the income and expenses on their personal returns. However, if the change of ownership takes place in the middle of the tax year, taxing an S corporation becomes much more difficult. If a stockholder disposes the entirety of his interest, the S corporation can close its books for the year and issue K-1s detailing the S corporation’s financial activity for the partial tax year to the old owner’s based on the old ownership percentages. At the end of the S corporation’s conventional tax year, the S corporation can then issue K-1s detailing the financial activity for the rest of the year divided based on the new ownership percentages. It is important to note that this can only occur if all stockholders agree to it, so often the retiring stockholders will insist upon this as a condition of the sale.
When acquiring a business, consult with a licensed attorney in your area to ensure all required paperwork is properly filed. If you are selling your S corporation shares, or if you are purchasing the S corporation, consult with a certified public accountant to ensure that all returns are appropriate filed. While every effort has been taken to ensure that this article’s completeness and accuracy, it is not intended to be legal advice.
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.