The S corp shareholder agreement is a contract between the shareholders of an S corporation. The contents of the shareholder agreement differ from one S corporation to another. The shareholders are also able to decide what goes into the shareholder agreement, which is also referred to as the stockholder agreement. Typically, the shareholder agreement addresses share ownership, share valuation, and the rights and responsibilities of the shareholder.

Subchapter S Corporations

A C corporation can elect to be taxed according to Subchapter S of the Internal Revenue Code. This election must be made with the IRS, and the corporation needs to meet the guidelines established in Subchapter S.

Once a corporation files Form 2553, which is called Election by a Small Business Corporation, the corporation becomes an S corporation. Form 2553 needs to be filed with the Internal Revenue Service (IRS).

Subchapter S election permits small corporations to be taxed like disregarded entity. The advantage of this is that the corporation doesn't need to pay income taxes at the entity-level. Instead, the profits and losses are passed to the shareholders. This enables the S corporation to avoid double taxation of dividends and net income. For a C corporation, the income is taxed at both the shareholder and the entity level.

Eligibility of an S Corporation

Corporations need to follow the rules established by the Internal Revenue Code in order to be able to make an election for Subchapter S. These rules are related to the number of shareholders that a corporation can have as well as the type of shareholders.

S corporations need to meet the following guidelines:

  • S corporations are not allowed to have more than 100 shareholders. 
  • An S corporation can only have one stock class, and the 100 or fewer shareholders must be individuals or certain types of tax-exempt trusts or entities.

Corporations, partnerships, and non-resident aliens are all ineligible shareholders. Financial institutions, insurance companies, and international sales corporations are all ineligible businesses.

If the shares of an S corporation are transferred to an ineligible shareholder, the Subchapter S election of the corporation terminates immediately. The S corporation immediately assumes the status of a C corporation. Automatic termination can have significant taxation consequences for a corporation.

S Corporation Advantage

Corporations need to pay taxes on the profits that they earn according to Subchapter C of the Internal Revenue Code. Subchapter C establishes the default tax rules for all corporations.

If the shareholders receive the profits as dividends, the shareholders need to pay income taxes on these dividends. These leads to the profits of the corporations being taxed twice. However, S corporations are able to avoid double taxation. 

The tax rules for an S corporation allow the profits of the corporation to be passed to the shareholders directly without taxation at a corporate level.

What is a Shareholder Agreement?

shareholder agreement is frequently referred to as a buy-sell agreement. This agreement serves as a contract between the shareholders that limits their ability to transfer shares.

Usually, small corporations use shareholder agreements to prevent the shareholders from transferring or selling their shares to outside parties.

If a shareholder wants to transfer or sell his ownership interest under the terms of a shareholder agreement, the shareholder will need to offer to transfer the shares to other shareholders first. Otherwise, the shareholder will need to get the shareholders to approve the outside party.

A shareholders agreement can prevent the sale of shares, set conditions, or establish penalties for various action related to shares.

What is a S Corporation Shareholder Agreement?

The vast majority of S corporations that have more than one shareholder should have written shareholder agreements. 

Even most family corporations should have shareholder agreements. In the event that some issues arise when it comes to shares, the shareholder agreement could resolve these issues without litigation.

S corporations usually create shareholder agreements to prevent shareholders from transferring or selling their shares to ineligible shareholders. Transferring shares to an ineligible shareholder could cause the Subchapter S election of the corporation to terminate immediately.

In most cases, the shareholder agreement of an S corporation will contain a clause for indemnity that requires the shareholder to pay the costs associated with changing tax status if the actions of the shareholders lead to automatic termination.

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