Many businesses are set up as corporations in order to protect their owners' personal assets from claims against the business. Yet most corporations suffer the downside of facing double taxation, with a corporate tax on business profits, and a second individual tax on money paid to owners as dividends.
To get around this, tax-savvy entrepreneurs often make a special election to set up what's known as an S corporation, which avoids this second layer of corporate taxation. However, S corporations have numerous restrictions, especially when it comes to who can own shares. As a result, there are some things you need to keep in mind if you're trying to transfer ownership of your S corporation shares to someone else.
The key to a good S corporation stock transfer
The most important rule governing S corporations is that there's a limit on the number of shareholders an S corporation can have. In order to prevent massive corporations from using this tax break, the tax laws require that an S corporation have no more than 100 shareholders. Going over the limit threatens the S corporation's tax-favored status, as the tax laws automatically revoke an S corporation election when the corporation no longer meets the requirements.
Moreover, only individual shareholders, as well as the estate of a deceased shareholder and certain types of trusts and charitable organizations, can own shares of an S corporation. The tax laws specifically exclude partnerships and other corporations from holding S corporation shares. In addition, non-resident aliens are not allowed to hold S corporation stock.
The 100-shareholder rule isn't quite as straightforward as it might seem. The tax laws allow groups of family members to be treated as a single shareholder for purposes of the 100-shareholder rule, including anyone who is a direct lineal descendant of a common ancestor who holds shares. That can include children, grandchildren, and others as many as six generations removed from the common ancestor, with spouses and former spouses also eligible.
Keeping your fellow shareholders happy
In addition to the restrictions imposed by the tax laws, many businesses establish shareholders' agreements that limit the ability of one shareholder to sell stock to whomever they want. Provisions of such agreements vary, but they often include a right of first refusal allowing existing shareholders to buy stock under the same terms offered to an outside buyer.
Some shareholders' agreements also set a specific price at which one shareholder can buy out another under certain circumstances. With S corporations, the agreement will almost always specifically state that no sale of stock can take place that would lead to a revocation of the corporation's tax-favored status.
Beyond that, formalizing the transfer of S corporation stock follows a similar process to most stock sales of regular corporations. A stock transfer agreement sets forth the terms and conditions of the sale, and the company will need to prepare new stock certificates that reflect the post-sale ownership stakes in the corporation. The new shareholder will also need to consent to the company's S corporation election in a written agreement.
By following these formalities, you can ensure that any transfer of S corporation stock goes smoothly. Otherwise, you could find yourself with a big problem on your hands.
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