When shareholders in an S corporation allow that business entity to buy out their share of ownership, the S corporation stops paying them any compensation or distributions based on the performance of those shares. The entity generally continues to pay the former shareholder a daily prorated amount for the balance of the fiscal year unless all shareholder agree to stop those payments from the day of the buyout. Pre-arranged buy-sell agreements funded by life insurance or other means can help facilitate a buyout in the event of a business partner’s death.
An S corporation’s buyout of a co-owner’s shares does not necessarily free either the corporation or the shareholder from certain accounting complexities. The CPA firm of Dugan & Lopatka explains that if the buyout occurs midway through a fiscal year, for instance, corporations must continue to allocate income to the former owner on a prorated daily schedule based on the number of shares in question. This amount of money counts as ordinary income, but the former owner will not participate in other compensation or distributions from the shares.
In some cases an S corporation may opt to stop paying ordinary income to the former shareholder on the precise date of the buyout instead of allowing the allocations to continue. Sellers may request this arrangement if they feel that this ordinary income cuts too deeply into their capital gains and reportable income losses. The corporation must have the consent of each of that year’s shareholders before it can make this election.
As part of the reporting requirements for a buyout, the S corporation’s accounting department must send the seller a Schedule K-1, including the total ordinary income loss for the fiscal year. The Internal Revenue Service describes Schedule K-1 as the standard document for reporting income from corporate entities. Sellers must include the total amount of ordinary loss for the fiscal year on this document when filing their tax returns. A former shareholder who disagrees with the amount listed on the K-1 can submit a Form 8082 to note and dispute the figure.
Buy-sell agreements can facilitate a buyout by establishing the terms and conditions in advance. A group of business partners may structure such an agreement to pre-set the value of the seller’s shares in the event of a buyout by the other owners or business partners. In some cases the company may take out a term life insurance policy to help fund the buyout if the shareholder dies, according to New York Life. These arrangements may exist either between the owners and the business entity or between the business entity and the shareholders.
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