Switching Ownership of the S Corp
One of the benefits of organizing your small business as a corporation is the built-in ownership transfer structure. Generally, owners of a corporation can transfer their interest in the company to someone else by simply selling their shares of stock. However, making a Subchapter S election for your small corporation comes with certain ownership restrictions that are imposed by the tax code.
Corporations are formed and operate under state law. While each state has its own corporation statute, the basics of corporation law are standard across states. Ownership of a corporation is represented by shares of stock, which are the holder's private property. Ordinarily, a stockholder can sell, give away or otherwise transfer his interest in a corporate at his discretion, unless the stockholders agree to impose transfer restrictions.
Subchapter S of the Internal Revenue Code allows a small corporation with no more than 100 stockholders to choose to be taxed as a pass-through entity. An S corporation doesn't pay corporate taxes as an independent taxpayer. Instead, it passes profits and losses through to its stockholders. Each reports his share of corporate profits and losses on his individual tax return and pays any taxes owed at his individual tax rate.
In exchange for this favorable tax treatment, the tax code places restrictions on ownership of S corporation stock to prevent business profits and losses passing through to individuals who are not required to file an individual federal income tax return in the United States. Only individuals and certain types of estates and trusts are allowed to be stockholders in an S corporation. Further, the individual can't be a nonresident alien.
Changing ownership in an S corporation follows the same procedure under state law as changing ownership in any corporation. One or more stockholders sell shares to another party. The sale process typically involves setting a price for the shares, making the transfer and updating the corporation's stock ledger. For tax purposes, an S corporation must report to the IRS and the prior stockholder her proportionate share of profits and losses for the portion of the year that the owner held the stock, using Schedule K-1 of the corporation's Form 1120S tax return. Likewise, the corporation issues initial K-1s to the new owners based on the portion of the year they held the stock and their ownership percentage.
Transferring stock to an ineligible stockholder under the tax code will automatically cancel the Subchapter S election, reverting the company back into a regular corporation that must pay corporate taxes. Most S corporations adopt stock transfer restrictions to prevent that possibility, since an unplanned tax change can have catastrophic consequences for the business and its owners.