One of the most frequently encountered scenarios in the context of a closely held business is the following:  individuals X and Y are shareholders of a corporation, X is the majority shareholder (60%) and president of the corporation, and X and Y do not have a shareholders’ agreement.  Over time, the interests of X and Y diverge, and X and Y begin to argue over the direction of the business.  Eventually, X attempts to shut Y out of the management and operation of the business.

The U.S. Tax Court recently considered this very situation, but with the following additional facts:  the corporation is an S corp.; it made no distributions to its shareholders during the period at issue; it issued a Schedule K-1 to each of X and Y, allocating corporate income based upon their relative stock ownership (60-40); and, although the corporation paid a salary to X, no wages were paid to Y.  Kramer v. Comr, T.C. Memo 2013-184.

In response to X’s having shut Y out of the corporation’s operation and management, Y filed a complaint in state court against X and the corporation seeking, among other things, the inspection of corporate records and the dissolution of the corporation.

The lawsuit eventually settled, with the settlement agreement providing that Y’s shares would be redeemed by the corporation, and that each of X and Y would be responsible for his respective tax liability.

On his individual income tax return, Y failed to include his share of the corporation’s income reported on the Schedule K-1 issued to him.  Y argued that he was not liable for the tax on such income because he was not the beneficial owner of shares in the corporation, notwithstanding his record ownership.  Y based his position on the fact that he was improperly excluded from the benefits of ownership.

The Tax Court rejected Y’s position, noting that it had previously held that when one shareholder merely interferes with another shareholder’s participation in the corporation, such interference does not amount to a deprivation of the economic benefit of the shares. In the absence of any agreement giving X any rights to Y’s shares during the period at issue, the Court said, X’s interference did not deprive Y of the economic benefit of his shares for tax purposes.  Thus, the Court held, Y was not relieved from reporting his share of the S corporation’s income on his tax return.

It appears that Y may not have argued that the corporation had more than one class of stock and, therefore, did not qualify as an S corporation.  However, this may be an argument that he should have considered.  In general, a corporation is treated as having only one class of stock if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds.  Nevertheless, an “arrangement” may be treated as a second class of stock if it constitutes equity under general tax law principles and a principal purpose of the arrangement is to circumvent the rights to distribution or liquidation proceeds conferred by the outstanding shares of stock. Query whether Y could have carried this burden.

The foregoing illustrates one of the many reasons why a minority interest in an S corporation, a partnership or an LLC, commands a valuation discount.  A minority owner in any of these pass-through entities must report his or her share of the entity’s net income regardless of whether or not he or she receives a distribution from the entity.  In the absence of a shareholder, partnership or operating agreement (as the case may be) that provides for annual distributions to the owners in an amount sufficient to enable the owners to pay federal, state and local income taxes on their share of the organization’s net income, an owner must look to his or her other assets to provide the cash necessary to satisfy those tax liabilities.  This can turn into an expensive proposition for a minority owner, especially for one who is not employed by (or otherwise engaged in) the business.

In most cases, a shareholders’ agreement will benefit primarily the principal (not necessarily majority) shareholder; for example, it may restrict transfers of shares, it may provide for drag-along rights by which the principal shareholder may compel the other shareholders to join him or her in disposing of their shares, it may require the minority shareholders to join in making an election under IRC Sec. 338(h)(10) to treat a stock sale as an asset sale, and it may provide for supermajority voting so as to give the principal shareholder veto power over certain corporate decisions.

However, anyone who is considering an equity investment in a closely held business that is a pass-through for tax purposes – especially someone who is not related to the other owners – should be careful of doing so without the protection that may be afforded by a shareholders’ agreement that provides for at least annual (perhaps quarterly) distributions for the purpose of enabling the shareholders to satisfy their income tax liabilities.  Although a potential investor must recognize a minority investment for what it is – with all its limitations – an investment in a pass-through entity should not turn into a net cash outflow beyond the amount invested solely because of income taxes attributable to the investment.