Key Takeaways

  • An S corp shareholder agreement is vital for outlining ownership rights and preventing disqualifying share transfers.
  • Unlike LLCs, S corps face strict IRS requirements, including shareholder eligibility and one class of stock.
  • Partnership-like tax treatment benefits S corps but doesn’t create a true legal partnership.
  • Shareholder agreements help maintain S corp status and minimize tax risks by limiting transfers to ineligible parties.
  • Clear protocols for profit distribution, dispute resolution, and succession planning should be detailed in the agreement.
  • Legal and tax advisors can help customize agreements to avoid pitfalls common with S corp elections.

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?

A 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.

Tax Considerations in a Shareholder Agreement

An effective S corp partnership agreement must reflect the IRS’s requirement that income, deductions, and credits flow through to shareholders proportionally. Key tax-related considerations include:

  • Distributions Must Match Ownership Percentages: Any clause enabling disproportionate distributions could create a second class of stock.
  • Basis Tracking and Distributions: Shareholders need to track their basis in the company for distributions and loss deductions.
  • Fringe Benefits Rules: Certain fringe benefits, such as health insurance for more-than-2% shareholders, are taxed differently and should be addressed in the agreement.

It’s wise to consult both legal and tax professionals when drafting the agreement to ensure it adheres to all S corp taxation rules.

Risks of Not Having a Formal Agreement

Without a formal shareholder agreement, S corporations risk internal disputes and potential loss of S corp tax status. Here are some common consequences:

  • Unintentional Transfers to Ineligible Parties: A shareholder might sell or bequeath shares to an ineligible person (like a non-resident alien), instantly revoking the S election.
  • Lack of Exit Strategy: Without buyout terms, exiting shareholders may disrupt operations or undervalue the business.
  • Inconsistent Expectations: When voting rights and distributions aren’t clearly defined, disagreements can lead to costly litigation or dissolution.

Legal advisors typically recommend implementing a comprehensive shareholder agreement even if the corporation is small or closely held.

Common Provisions in S Corp Shareholder Agreements

To remain compliant and functional, most S corp shareholder agreements contain provisions tailored to both legal requirements and business goals:

  1. Transfer Restrictions
    Prohibits transferring shares to ineligible shareholders to protect the S status. Often includes a right of first refusal or mandatory sale back to the company or other shareholders.
  2. Tax Indemnification Clauses
    Requires shareholders to indemnify the company if their actions (e.g., improper transfers) cause the termination of S corp status or result in IRS penalties.
  3. Dispute Resolution
    Specifies whether mediation or arbitration will be used in case of shareholder disagreements.
  4. Succession and Buyout Terms
    Details how shares are handled upon death, disability, or voluntary departure of a shareholder.
  5. Distribution Policies
    Clarifies when and how profits will be distributed, and whether distributions will be made in proportion to ownership, in compliance with the one-class-of-stock rule.
  6. Voting Rights and Governance
    Outlines how corporate decisions are made, especially where majority vs. unanimous consent is required.

S Corp Partnership Agreement vs. Traditional Partnership Agreements

Although an S corp may function similarly to a partnership in terms of pass-through taxation, it differs significantly in structure and requirements. A traditional partnership agreement applies to partnerships governed under partnership law, which allows for more flexibility in ownership classes, profit sharing, and management.

In contrast, an S corp partnership agreement — often used as a search term to refer to a shareholder agreement — must adhere to the following IRS limitations:

  • Only one class of stock is allowed, which limits differential profit distributions.
  • Shareholders must be individuals, estates, or certain trusts; partnerships and corporations are not allowed.
  • Allocations must be proportional to share ownership.

This means the agreement must avoid creating arrangements that mimic a second class of stock or preferential distributions, which could invalidate the S election.

Why an S Corp Shareholder Agreement Is Crucial?

A well-drafted S corporation shareholder agreement is crucial for preserving the corporation’s S election and preventing disputes. Since S corporations can only have one class of stock and a limited pool of eligible shareholders, it's essential to structure ownership rights carefully. A shareholder agreement helps ensure all stakeholders understand their roles, responsibilities, and limitations, reducing the risk of inadvertent errors that could cause IRS penalties or termination of S status.

Key functions of an S corp shareholder agreement include:

  • Restricting share transfers to avoid disqualifying entities such as partnerships, corporations, or non-resident aliens from becoming shareholders.
  • Establishing buy-sell provisions that define what happens when a shareholder wants to exit or passes away.
  • Clarifying voting rights and management responsibilities, especially for closely held corporations.
  • Defining profit and loss allocations, distributions, and decision-making thresholds to avoid disputes.

Frequently Asked Questions

  1. Can an S corp have a partnership agreement?
    Not in the traditional sense. While some refer to a "s corp partnership agreement," S corporations must use a shareholder agreement that complies with S corp rules.
  2. What happens if an S corp shareholder transfers shares to a corporation or partnership?
    The S corp status is automatically terminated, and the corporation will be taxed as a C corporation unless corrective action is taken.
  3. Is a shareholder agreement required for an S corporation?
    It’s not legally required but is highly recommended to prevent conflicts and protect the S election status.
  4. Can an S corp shareholder agreement allow for different voting rights?
    Yes, as long as all shares confer identical rights to distribution and liquidation proceeds to maintain a single class of stock.
  5. Should LLCs elect to be taxed as S corporations?
    Not always. While S corp taxation offers pass-through benefits, there are restrictions and administrative requirements that may outweigh the benefits for some LLCs​.

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