The only IRS form that needs to be completed is adding a new K-1 when the Form 1120-S is prepared. As a sole owner, the Form 1120-S includes a single K-1 showing 100 percent ownership. If you add one partner, the tax preparer adds an additional K-1 with the updated ownership percentages. 

The Tax Impact of Adding a Shareholder in an S Corp

1. Transfer shares to the new partner as compensation – In this scenario, the fair value (based on the valuation) of the transferred shares will be treated as taxable income to the new partner (via W2). The S corp takes a deduction for the related compensation expense.
2. Issue additional shares for the business to issue to the new partner – The new partner pays the fair market value of the newly issued stock. For example, if the business is valued at $1 million and the new partner is acquiring 25%, they can contribute $250,000 to the business in exchange for 25% of the stock. Any payments less than fair value would be considered taxable income to the new partner. The downside of this method is the additional legal costs associated with issuing new shares and updating organizational documents. 
3. The original owner transfers their shares in exchange for cash – In this situation, the original partner sells a portion of their shares in exchange for cash. Assuming the new partner pays fair market value in exchange for the shares, the new partner would not have a taxable event. Since the original partner receives cash in exchange for their shares, this results in a capital gain or loss. The capital gain or loss is calculated based on the proceeds less the tax basis in the shares. For example, the original owner had a basis of $100 thousand in the company. If they exchanged 25 percent of their shares, the original partner’s basis in those shares would be $25,000 (25% of $100 thousand). If the original owner received $250,000 in exchange for 25 percent of the shares, the original owner would report a capital gain of $225,000 ($250,000 cash received less $25,000 basis).

The important aspect to remember is that each deal has its own unique characteristics. The tax impact will be different depending on the legal language of the share transfer. Engage an attorney and experienced CPA to assist with the tax implication and calculations. If you would like a referral to a couple of attorneys please select the following link – Click Here.