Key Takeaways:

  • Check Shareholder Agreement First: The agreement may contain a set process for removing a shareholder.
  • Legal Compliance: If no agreement exists, follow state corporate statutes.
  • Voluntary vs. Involuntary Removal: Different approaches are required depending on whether the shareholder agrees to leave.
  • Buyout Process: Shareholders typically need to be compensated for their shares.
  • Board & Shareholder Votes: Majority votes from the board or shareholders may be required.
  • IRS & S Corp Compliance: Ensure removal doesn't impact S Corporation status.
  • Dispute Resolution: Mediation or legal action may be needed in contested removals.
  • Attorney Assistance: Consulting a corporate attorney can ensure compliance and minimize legal risks.

Removing a shareholder from a corporation is a very involved process. Hopefully, your shareholders agreement will have a procedure for removing a shareholder. Typically, removing a company shareholder requires a majority vote of your other shareholders.

Refer to Your Shareholders Agreement

Checking your shareholders' agreement should be the first step you take if you need to remove a shareholder. Depending on your specific agreement, there may be a set procedure for shareholder removal. The purpose of a shareholders agreement is to define the duties and rights of shareholders in a corporation.

A shareholders' agreement guarantees fair treatment of all shareholders and ensures that every shareholder knows their rights and responsibilities within the company. A properly written agreement will make it easier to remove a shareholder later on.

Basically, a shareholders agreement functions as a contract that tells shareholders what they can and cannot do within the company. For instance, if your company's agreement includes rules of conduct, you should be able to easily remove a shareholder who repeatedly violates these rules.

Removing a majority shareholder—one who owns over half of the company's shares—for violating conduct rules is easier than removing them on other grounds. If a majority shareholder breaks a rule specifically outlined in the agreement, you shouldn't have any trouble removing them from the company.

When writing your shareholders agreement, it's crucial that you include detailed information about your company:

  1. A capitalization table
  2. How many shares you will issue
  3. Rules for share transfers
  4. If shareholders have preemptive rights to purchase company shares
  5. How shareholders will get paid if the company is sold

Including the right details in your agreement will make it easier to remove a shareholder in the future.

Buyout Agreements and Valuation Methods

In cases where the shareholders agreement includes a buy-sell agreement, this document typically dictates the valuation method for shares and outlines how a buyout should occur. Common valuation methods include:

  • Fair Market Value (FMV): Determined by an independent appraiser.
  • Book Value: Based on the company’s financial statements.
  • Capitalized Earnings: Evaluates future earnings potential.
  • Agreed Price: A predetermined price agreed upon in the shareholder agreement.

If no valuation method is specified, hiring a financial expert may be necessary to ensure fair pricing.

Help From an Attorney

If you review your shareholders' agreement and find that there is no protocol for removing a shareholder, there are a few ways you can proceed.

First, check the corporate statute in your state. If your shareholders agreement does not specify how to remove a shareholder, the rules of the corporate statute will apply. Every state has its own laws for corporations and how they can remove shareholders.

Second, you should consult a corporate attorney who specializes in corporate law in your state. Your attorney can help you follow the corporate laws in your state so that the shareholder is removed properly.

Ensuring Compliance with S Corporation Rules

S Corporations have strict IRS requirements regarding shareholder eligibility. If a shareholder no longer meets IRS qualifications—such as converting into a corporate entity rather than remaining an individual—their removal may be necessary to maintain S corporation status. If an improper removal process is followed, the company could face legal disputes or even risk losing its S Corp status.

An attorney can help navigate compliance by:

  • Ensuring the removed shareholder is compensated fairly.
  • Verifying that new ownership aligns with IRS rules.
  • Filing necessary documentation with the IRS and state authorities.

Voluntary vs. Involuntary Removals and Company Resolutions

If you want to remove a shareholder, you first must decide if the shareholder is leaving the company voluntarily or involuntarily. For involuntary removals, the shareholder will usually need to have violated the shareholders agreement or company bylaws before they can be forced out of the company.

Drafting a shareholder removal resolution should be your next step. After drafting the resolution, you should present it to your corporation's board of directors. Depending on your shareholders agreement, you may instead need to present the resolution to a specific group of shareholders.

The resolution needs to include the correct information before you can remove a shareholder. For instance, you need to explain the reason for removing the shareholder and include a buyout request. If you want the resolution to be as effective as possible, your reasons for removing the shareholder should include a bylaw violation. With an S Corporation, for example, you could state that you are removing the shareholder because they no longer meet the Internal Revenue Service (IRS) qualifications for serving as an S Corp shareholder.

An involuntary removal can only occur if your shareholders agreement describes the process for such a removal. Otherwise, you cannot force out a shareholder until they have violated the corporate statute. In most cases, this would mean that the shareholder has committed fraud. After everything is in order, your corporate secretary and board of directors should sign the removal resolution.

Next, you should convene a meeting of your company's governing board to vote on the resolution. If the board passes the resolution, you'll need another signature from your corporate secretary.

If there is no shareholders' agreement in place, or if the shareholder to be removed hasn't violated company rules, the resolution must pass by a 75% majority vote. Also, the shareholder in question cannot own more than 25 percent of the company's shares.

Steps for Removing a Shareholder

Removing a shareholder from an S Corp generally follows these steps:

  1. Review Corporate Bylaws and Agreements: Check for shareholder removal clauses.
  2. Determine Grounds for Removal: Voluntary departure, misconduct, or failure to meet IRS requirements.
  3. Draft a Resolution: Document the reasons and terms for removal.
  4. Vote for Approval: Gain necessary board or shareholder approvals.
  5. Execute the Buyout: Follow the valuation and payment terms outlined in the shareholders' agreement.
  6. Update Corporate Records: File amendments with the Secretary of State if necessary.
  7. Notify the IRS: Ensure the company remains compliant with S Corp regulations.

For involuntary removals, mediation or litigation may be necessary if the shareholder contests the process.

Frequently Asked Questions

  1. Can an S Corporation force a shareholder to sell their shares?
    Yes, but only if the shareholders agreement or bylaws include a provision allowing forced buyouts. Otherwise, legal action may be required.
  2. What happens if removing a shareholder violates the S Corp requirements?
    If the removal causes the company to have an ineligible shareholder, it could lose its S Corp tax status and default to a C corporation.
  3. How is a shareholder’s stock value determined for a buyout?
    The valuation method should be outlined in the shareholders agreement. If not, a business valuation expert may be needed.
  4. What legal risks exist in removing a shareholder?
    Risks include potential lawsuits, IRS penalties, and financial disputes over share value.
  5. How can UpCounsel help with shareholder removal?
    UpCounsel connects businesses with experienced corporate attorneys who can guide them through legal requirements and shareholder disputes.

If you need help with removing a shareholder, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.