S Corporation Shareholders Agreement

Incorporating your business is a good way to protect your personal assets, but you must also consider other factors. A corporation with only a few shareholders running a small business needs to consider the tax ramifications of incorporating, as well as plan for events such as a transfer-of-stock ownership. Two things that generally benefit a corporation's shareholders are choosing to be an S corporation and making a shareholders agreement.

The default tax rules for corporations set forth in Subchapter C of the Internal Revenue Code require that corporations pay taxes on their profits. When the profits are distributed to the shareholders as dividends, the shareholders must pay income tax on the dividends. This results in the corporation’s profits effectively being taxed twice. However, this double taxation can be avoided if your corporation qualifies to be taxed under Subchapter S of the Internal Revenue Code. These tax rules allow you to pass the corporation's profits directly to the shareholders without taxation at the corporate level.

Your corporation qualifies as an S corporation if it meets the following IRS requirements: no more than 100 shareholders; only one class of stock; no ineligible shareholders; and not an ineligible business. The ineligible shareholders include partnerships, corporations and non-resident aliens, and the ineligible businesses include insurance companies, certain financial institutions and international sales corporations. If these requirements are met, your corporation acquires S corporation status when you file Form 2553 "Election by a Small Business Corporation" with the IRS.

Your state’s corporate law sets the basic rules for operating your business as a corporation. However, these rules may not necessarily meet the needs of shareholders. For example, the S corporation rules are set by the IRS, and state law does not require that shareholders follow these rules. To ensure that a shareholder doesn't undermine the corporation’s S status, you can make a shareholders agreement that addresses this issue, as well as other matters of importance to shareholders. The shareholders agreement can be made at any time, but is best made when your business is incorporated.

Using a shareholders agreement to help maintain your corporation’s S status requires addressing a few basic issues. The agreement should include a provision prohibiting a shareholder from transferring stock to an ineligible shareholder. In the event a shareholder causes the corporation to lose its S status, the agreement should also include an indemnity provision that requires that shareholder to compensate the corporation or other shareholders for any monetary losses that result. However, because the needs of every corporation and its shareholders are unique, you should consult with an attorney regarding preparation of a shareholders agreement.