Key Takeaways

  • An S corp partnership agreement defines the roles, responsibilities, and ownership restrictions among shareholders.
  • S corporations cannot be owned by partnerships or other corporations; all shareholders must be eligible individuals or entities.
  • Shareholder agreements help protect S corp status by ensuring compliance with IRS rules, especially the one-class-of-stock rule.
  • Provisions in these agreements often cover ownership transfers, buy-sell terms, income distribution, and dispute resolution.
  • In mergers or acquisitions, poorly structured shareholder agreements can jeopardize the S corp election and tax treatment.

An S corp partnership is possible. In fact, an individual launching a business can be an S corporation, a C corporation, an LLC or a sole proprietorship. When two people launch a business, they can form a partnership, an LLC, an S Corporation or a C corporation.

Choosing a Business Entity Type

When deciding on business form, you should consider both state law and tax matters when determining the form for your business. Note as follows:

Partnership

  • A general partner has unlimited liability for business debts.
  • To avoid liability, you can form a limited partnership, or LP, provided that there is at least one general partner and one limited partner.
  • In such an instance, a general partner has unlimited liability while a limited partner will have liability to the extent of his or her contribution to the partnership.
  • A partnership may contain different classes of partners and is provided flexibility with respect to allocating profits and losses to the various sets of partners.
  • Liabilities may increase based on a partner's portion in the partnership, which can offset cash distributions and reduce taxation.
  • A partner who contributes appreciated property to a partnership is generally not liable for tax on the contribution, even if that partner is not a controlling partner.

Corporation

  • A corporation will have limited liability.
  • A shareholder, in general, will not be responsible for corporate liabilities outside of his or her contributions to the corporation.

Concurrently, it is very important to consider federal tax obligations and consequences when choosing a form of business entity.

Tax Matters

  • A significant concern is avoiding a double taxation, wherein business income is taxed on the corporate level and employees and shareholders pay tax on a personal level.
  • To avoid this tax liability, create a form that is taxed as pass-through entity, which can be an S corporation or a partnership.
  • Pass-through means that business income is not taxed at the corporate level and instead “passes through” to shareholders or partners, depending on the entity, and is then taxed at each individual’s personal rate.
  • C corporations, in contrast, are subject to double taxation taxable entities.
  • Note that income of a pass-through business entity is taxable to its shareholders or partners, regardless of whether the shareholder or partner actually received a distribution.
  • Dividends, in contrast to income, are taxed only when an actual distribution occurs.

S Corporation

  • State law governs organizing a partnership whereas the federal tax system governs an S corporation.
  • In respect of state law, an S corporation has regular corporation status.
  • In terms of distributing shares, an S corporation is limited to 100 shareholders with only specific individuals, estates, and trusts as eligible shareholders.
  • In terms of eligibility, a C corporation or a nonresident alien are barred from being a shareholder in an S corporation.
  • S corporation stock is capped at a single class of stock.
  • Any income or loss is allocated on a pro rata basis to all shareholder.
  • Note that having just one class of stock can affect the S corporation's ability to raise capital.

Understanding S Corp Partnership Agreements

Although partnerships and S corporations are distinct legal entities, some business owners refer to their joint S corp ownership as a “partnership.” However, it's essential to understand that S corporations cannot be owned by partnerships. Under IRS rules, only eligible shareholders — such as U.S. citizens, resident individuals, certain trusts, and estates — can hold stock in an S corporation.

This means that while individuals can co-own an S corporation and draft a shareholder agreement to outline their roles and profit allocations, the entity itself is not a partnership. Instead, it is a pass-through corporation subject to specific IRS restrictions, including the one-class-of-stock requirement. Any attempt to treat the arrangement like a traditional partnership — such as allocating profits unequally without using stock percentages — may violate S corp eligibility rules and risk termination of S status.

S Corporation v. Partnership

Forming a partnership is relatively easy in that it has no paperwork requirement. In fact, partnership creation can occur without intention. This happens when two people start working in a business together.

On the other hand, an S corporation has complex registration requirements:

  • First, the business is to register as a corporation (S or C) or as an LLC in the state where it primary performs its business. This usually requires drafting an articles of incorporation document or an articles of organization document.
  • Second, once submitted, the company is to complete and file an IRS Form 2553, which makes an S corporation election.

Partnerships, as opposed to S corporations, have flexibility with respect to company structure in regard to both management and p & l allocation. Regarding management, the default rule is that all partners have equal say notwithstanding share of ownership. The partnership is flexible to create a structure that has other management arrangements. For instance, the partners agree that one partner will be the managing partner. Another example is partners create a system of different shares of p & l notwithstanding ownership interest.

For S corporations, shareholders elect a board of directors, which is tasked to oversee company management, including appointing officers to oversee daily operations of the company. There is no flexibility regarding profits and losses. Those are per shares owned.

Importance of an S Corp Partnership Agreement

An S corp partnership agreement — more accurately referred to as an S corporation shareholder agreement — is a legal document that helps prevent internal disputes and ensures compliance with IRS requirements. This agreement outlines shareholder roles, ownership percentages, profit distributions, transfer restrictions, and procedures for handling disputes or exit events.

Key benefits of a well-drafted S corp partnership agreement include:

  • Maintaining S Corp Status: The agreement can prevent actions that would jeopardize the S election, such as transferring shares to an ineligible shareholder or issuing a second class of stock.
  • Clear Succession Planning: It defines rules around death, disability, divorce, or departure of a shareholder, often including buy-sell provisions to guide share transfers.
  • Dispute Resolution: It provides frameworks for resolving disagreements without litigation, protecting the company from internal conflict.
  • Equity Management: It clarifies restrictions on issuing new shares, voting rights, and conditions under which shares can be sold, assigned, or redeemed.
  • Capital Contributions and Distributions: It can specify whether additional capital contributions are expected from shareholders and how distributions will be handled (within the boundaries of IRS pro-rata requirements).

While S corps must treat shareholders equally regarding distributions and stock rights, a shareholder agreement ensures those rules are understood and followed.

Risks in M&A Without a Strong Shareholder Agreement

In merger or acquisition scenarios, an inadequate or poorly structured S corp partnership agreement can expose the company to significant tax risk. For instance, if a buyer inadvertently acquires stock in a way that violates S corp eligibility (e.g., acquiring through a partnership or foreign entity), the S election may be invalidated retroactively — triggering corporate-level taxation.

To avoid this, shareholder agreements should:

  • Restrict share transfers to ineligible entities.
  • Require advance notice and approval for transfers.
  • Include language affirming adherence to the one-class-of-stock rule.
  • Mandate cooperation among shareholders to maintain the S election and file related tax forms.

For businesses planning future exits or sales, these provisions are crucial to preserving the tax advantages of S corp status and avoiding unnecessary IRS scrutiny.

Drafting Tips for an S Corp Partnership Agreement

When drafting an S corp partnership agreement, legal precision is critical. The agreement should:

  • Clearly define roles and obligations of shareholders.
  • Outline stock transfer restrictions to maintain S corp eligibility.
  • Ensure all economic rights attached to shares are identical, upholding the one-class-of-stock rule.
  • Provide procedures for voting, deadlocks, and dispute resolution.
  • Include provisions for valuation and purchase of shares during exit events (e.g., retirement, death, or divorce).

The agreement should be reviewed regularly and updated as business circumstances change. Additionally, consulting a business attorney familiar with IRS S corp rules can help ensure the agreement is enforceable and compliant.

Frequently Asked Questions

  1. Can a partnership be a shareholder in an S corporation?
    No. Partnerships, corporations, and nonresident aliens cannot be shareholders in an S corporation. Only eligible individuals, certain trusts, and estates can hold S corp stock.
  2. What is the purpose of an S corp partnership agreement?
    An S corp partnership agreement, or shareholder agreement, governs the relationship among shareholders, ensuring compliance with IRS rules and preventing internal disputes.
  3. How does a shareholder agreement protect S corp status?
    It helps prevent unauthorized share transfers and actions that could invalidate the S election, such as violating the one-class-of-stock requirement.
  4. Can S corp shareholders have different profit-sharing arrangements?
    No. S corporations must allocate profits and losses strictly based on share ownership, unlike partnerships, which allow flexible profit-sharing arrangements.
  5. Do I need a lawyer to draft an S corp shareholder agreement?
    While not legally required, using a lawyer is highly recommended to ensure compliance with federal tax laws and to craft enforceable, effective provisions.

If you need help setting up your S corporation, 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.