The Redemption of an S Corporation Shareholder

Although buying into an S Corporation is as simple as signing a contract to purchase shares, redeeming shares can be a different matter. S Corporations are not allowed to have more than 75 shareholders. Because of this rule, S Corporations rarely trade publicly, making share redemption a challenge for both the ownership group and selling investor. Following a few simple guidelines can allow the redeemer to experience potentially lower tax consequences.

Any person trying to redeem shares of small corporations must be prepared to prove the sale changes their voting influence on the company. If not, the IRS will classify the transaction as a distribution rather than a sale. To meet IRS guidelines, the redemption must not be substantially equivalent to a dividend, and must change the ownership level of the seller. The redeeming shareholder must own less than 50 percent of the voting stock after the redemption and less than 80 percent of the voting stock that was outstanding before the transaction.

If a sale of shares doesn’t meet IRS requirements, then the sale is deemed to be a distribution by the IRS. This means that the sale will be included as ordinary income on the redeeming shareholder’s tax return. A married person with a taxable income of $100,000 in 2010 will pay 25 percent tax on ordinary income, while a sale would trigger a capital gains tax at a maximum rate of 15 percent.

By completely liquidating his shares, the shareholder eliminates the chance that the IRS will find that the redemption of stock does not meet its standards. Termination of ownership reduces the claims of the former shareholder to zero, except in the case of sales to family members. In this case, the IRS does not recognize the sale without further documentation.

When shares are sold to a family member, there are a number of IRS “attribution rules” that limit the sale to a distribution. These rules were created to curb the ability of family members to illegally manipulate IRS rules to suit their needs. When stock is sold to a family member, no losses on the stock may be claimed until the shares are sold outside of the family. Shares sold to family members are recognized as ordinary income rather than capital gains. Family members may petition the IRS for a waiver of family attribution, which limits their involvement with the company in exchange for capital gains tax treatment.

Closely held S Corporations need to have a professional evaluation completed to determine the worth of stock shares. This will determine the taxation of shares. IRS guidelines specify that the parties follow the fair market value standard when transferring property. The criteria of this policy are numerous and include history of the business, economic outlook, book value, earning capacity and dividend-paying capacity. Shares of an S Corporation are legally freely transferrable, but most small companies have share transfer-restriction agreements, specifying conditions under which a shareholder may redeem shares.