An S corporation is a corporate entity that meets certain restrictions set by the Internal Revenue Service so that its income is not taxed at the corporate level. Instead, profits pass through the business and the shareholders report the distributions of those profits on their individual tax returns. To avoid potential problems, the shareholders should draft an S corporation shareholder agreement.
Importance of a Shareholder Agreement
The shareholder agreement is a contract between the owners of a corporation. It is an important document in any type of corporation, but for S corporations in particular it can protect the business from losing its S corporation election. According to an article by Stephen Looney and Ronald Levitt, a shareholder agreement can restrict the shareholders abilities to transfer shares to an ineligible person or entity. If a shareholder breaks that agreement, contract law principles provide remedies to the business and the other shareholders.
There are several issues to consider when drafting an S corporation shareholder agreement. Since S corporations tend to be small, the agreement should contain “tie-breakers” to avoid deadlocks, according to the website Creators.com. The agreement should discuss how a member’s interest is valued and provide the business with a right of first refusal -- meaning that the shareholders must first offer their interests to the company before entertaining other offers -- and other restrictions on stock transfers, according Dummies.com. Additionally, the agreement should provide clauses for raising capital, resolving disputes, voting and issuing stocks.
Notice of Restrictions
Restrictions on stock transfers and other matters that could affect the status of an S corporation need to be written in a shareholder agreement, but the corporation can take additional steps to put interested parties on notice of those restrictions. According to the article by Looney and Levitt, the corporate bylaws and stock certificates can reference the restrictions found in the shareholder agreement. This puts the public or other interested parties on notice that restrictions to the stocks of that particular company exist.
A shareholder agreement must be drafted according to address the unique and specific concerns of a particular business venture. While template agreements exist, drafters should be wary to simply cut-and-paste the clauses verbatim; rather the agreement should be tailored to the business. A shareholder agreement is a legal document that affects the legal rights and responsibilities of the parties involved. It should be drafted or at the very least reviewed by an attorney before each shareholder signs the agreement.