After setting up a corporation, your company must understand and follow the corporate laws of the specific state in which you filed the articles of incorporation. These laws offer guidance on many important topics. However, for many corporations, the most important sections of the state-specific corporate laws deal with establishing the activities and conduct that shareholders and directors must follow or are prohibited from engaging in. Aside from laying out allowed conduct from shareholders and directors early in the company’s life, another benefit of these state laws is that they allow the owner or partners of a company to create specific bylaws that cover important topics such as company control, ownership, and contractual relationships between shareholders.
Furthermore, these state laws are extremely important to understand and utilize if a company is set up as an S corporation. The reason for this is that an S corps allows up to 100 different shareholders benefit from incorporation while being taxed as partners. Thus, it is extremely important that a company with this management structure has strict laws stating what shareholders must do when acting for the business and the duties that they owe other shareholders.
To establish these necessary laws, companies can utilize an S corp shareholder agreement—also known as a stockholder agreement. This agreement is a contract between the shareholders of an S corporation and the corporation itself. What a contract includes will differ from company to company. The reason for this is that the shareholders of the S corp can decide what topics will be covered in the agreement. However, most S corp shareholder agreements will cover share ownership, share valuation, and the rights and responsibilities of the shareholder.
Subchapter S Corporations
A C corporation can choose to be taxed as an S corporation if the company meets the requirements specified in the Subchapter S of the Internal Revenue Service (IRS). Furthermore, a company must make this decision with the IRS and they must meet each requirement that the IRS has for these types of corporations. To become an S corporation, a company must fill out and file form 2553 with the IRS.
Once a company files and is granted this corporate structure, businesses that have under 100 shareholders will be taxed as a disregarded entity. What makes this business structure so desirable for many companies is that the business does not pay income taxes at the company level. Instead, the profits or losses a company experiences pass to the shareholders, matching the ownership percentage of each individual shareholder. Thus, S corps avoid the double taxation of dividends and net income that C corporations and their shareholders must pay.
Eligibility of an S Corporation
As stated above, corporations must meet the criteria laid out by the IRS in order to become an S corporation. Furthermore, to become an S corps, a company can only have a limited number of shareholders. Additionally, the shareholders can only consist of individuals, specific trusts and estates, or certain tax-exempt organizations. Finally, partnerships, specific financial institutions, corporations, insurance companies, and nonresident aliens cannot be shareholders of S corps.
It is extremely important to know what entities shareholders in an S corps can be and correctly identify the legal standing of your shareholders. The reason for this is that if any share of an S corporation transfers to an ineligible shareholder, the Subchapter S distinction immediately terminates and the company assumes the C corporation structure. This disrupts everyday business. However, it also leads to significant taxation that the company would otherwise not have to pay.
S Corporation Advantage
The main advantage of utilizing an S corporation is the tax incentives that the shareholders of the company receive. In a normal C corporation, the profits of a company are taxed initially. Additionally, tax also applies to the dividends that shareholders receive. This means that any profits or income a company receives will be taxed twice. However, an S corp removes corporate-level taxation. Thus, the only time company profits will be taxed is when the individual shareholders pay income taxes.
Shareholder Agreements
Companies most commonly use shareholder agreements as a contract between shareholders of a company. The main function of this agreement is to limit the current shareholder’s ability to transfer shares to another party. Typically, small or family-held businesses will use this agreement. The reason for this is so harmful entities will not have a say in the management of the company.
To achieve this goal, a shareholder agreement requires a shareholder to offer their shares to other current shareholders first. Furthermore, a shareholder selling their shares to an outside party must receive approval from the other shareholders. In most cases, a shareholder agreement can prevent the sale of shares, establish penalties for actions related to the shares, and set conditions for the sale of shares.
What is a S Corporation Shareholder Agreement
If an S corporation has more than one shareholder—even if the company is family-owned—they should have a shareholder agreement. By enacting a shareholder agreement, if legal issues between the shareholders occur, the company can resolve the issues without litigation. If an ineligible party owns part of an S corp, the company loses this status and reverts to C corps. Thus, many S corp shareholder agreements contain a protectionary clause. This clause states if a shareholder sells a share to or is an ineligible shareholder, they have to pay the extra taxes associated with reverting to a C corporation.
Final Thoughts
Tax laws are complex. This is so no matter the type of corporate structure you decide to establish. As such, it is extremely important to have legal representation to ensure you correctly set up your business. The Antonoplos & Associates business and tax lawyers have over 20 years of experience helping clients in DC, Maryland, and Virginia. With this knowledge and experience, we can help with any legal issues that occur from setting up your business.
Furthermore, Peter Antonoplos, founder and managing partner of Antonoplos & Associates has an LLM in Taxation from Georgetown University Law Center. With this knowledge, Peter can help you effectively set up your S corporation or other corporate structures you utilize. Thus, maximizing the tax savings you receive from setting up this corporation in DC, Maryland, and Virginia.
Contact Our DC Law Office for More Information
Finally, for more on S corps shareholder agreements, contact us at 202-803-5676. You can also directly schedule a consultation with one of our skilled attorneys. Additionally, for general information regarding business and tax law, check out our blog.