During their life cycles, most closely held businesses will face the unpleasant task of dealing with a difficult, or otherwise unwanted, minority shareholder. Family-owned businesses as well those in which the owners are unrelated are likely to encounter this issue. At some point in its existence, the original owners of the business will: have a major disagreement, transfer equity to members of their family (who may not be involved in the business), otherwise dispose of some portion of their interests (e.g., by sale to a third party or divorce), or admit new owners.
Many businesses owners try to plan for at least some of these events through their shareholder or operating agreements. These agreements may include rights of first refusal, call rights, periodic put rights, other transfer restrictions, special quorum, voting or other governance-related restrictions, and/or rules as to distributions (e.g., as to taxes), and they will generally be binding upon any subsequent owners. It is difficult, however, to foresee every contingency, and it simply may be impossible for the owners to settle upon a “complete” set of mutually acceptable provisions.
In that case, the issue of the unwanted minority shareholder may linger, and may eventually become a real problem. Business owners have been very creative in how they deal with such persons. In some cases, for example, they may stop declaring dividends, thereby depriving the minority owner (who is usually not employed by the business) of any economic benefits from the business; indeed, where the business is a pass-through entity for tax purposes, like an S corporation, the minority owner nevertheless will be stuck with a tax liability in respect of its share of the business profits.
One Company’s Solution
The IRS recently addressed the approach taken by one corporation (“Corporation”). Corporation was treated as an S corporation for tax purposes. In order to increase the operational flexibility of Corporation, and to reduce costs and eliminate certain administrative burdens associated with Minority Shareholder, the Continuing Shareholders and Corporation undertook the following transaction, a form of “squeeze-out”:
- The Continuing Shareholders formed a new corporation (“Newco”) solely for the purpose of effecting the removal of Minority Shareholder.
- Each of the Continuing Shareholders contributed all of their shares of Corporation to Newco in exchange for shares of Newco in equal proportions (the “Contribution”). They do not appear to have contributed any cash to Newco, though they certainly could have.
- Newco merged into Corporation, with Corporation as the surviving entity (the “Merger”).
- In connection with the Merger, the Minority Shareholder received a specified cash amount per share in exchange for the Minority Shareholder’s Corporation stock, and such stock was cancelled.
- If the Minority Shareholder had objected to the proposed transaction, the Minority Shareholder would have had the right to exercise dissenter’s rights under state law and receive the fair value of Minority Shareholder’s shares.
- Also in connection with the Merger, the Newco shares owned by the Continuing Shareholders were cancelled and each received shares of Corporation stock in the same proportions as the shares they held in Newco in exchange for their previously held Newco stock (the “Share Exchange”).
- After the completion of the proposed transaction, each of the Continuing Shareholders held a number of shares in Corporation equal to the proportions that those Continuing Shareholders held immediately before the transaction.
The IRS ruled that the creation of Newco, followed by the merger of Newco into Corporation, would be disregarded for Federal income tax purposes; in other words, the IRS would pretend that Newco never existed. Instead, the transaction would be treated as if the Continuing Shareholders had never transferred their Corporation stock for Federal income tax purposes, and thus the Continuing Shareholders would not recognize any gain or loss from the transaction. The transitory ownership of Corporation by Newco would not cause the termination of Corporation’s S corporation election (a corporation is not a qualified S corporation shareholder).
The IRS further ruled that the cash received by the Minority Shareholder in the transaction would be treated as a distribution by Corporation in redemption of the Minority Shareholder’s stock. Because Minority Shareholder’s equity would be completely eliminated, and assuming Minority Shareholder was unrelated to Continuing Shareholders, Minority Shareholder would likely recognize capital gain as a result of the transaction.
The net result of the overall plan described above was the forced removal of the minority shareholder, effected by the purchase of such shareholder’s shares for cash, and the preservation of the corporation’s “S” election (and other tax attributes). While the tax structure was “right on,” and the enumerated steps seem straightforward enough, they undoubtedly belie, and were preceded by, a long period of turmoil within the business that probably included legal posturing by both sides (plus the attendant costs), threats by the minority shareholder of stock transfers to non-qualified S corporation shareholders and/or threats of “informing” the IRS as to perceived violations of S corporation requirements (e.g., the “single class of stock” rule), not to mention a lot of anguish.
Additionally, the ruling did not seem to involve other complicating factors, for example, the disposition of any life insurance that the corporation may have held on the life of the departing shareholder, the tax treatment of any deferred compensation-like payments that could have been required if the shareholder had also been an employee, or the future involvement in the business of any members of the departing shareholder’s family.
A “business divorce,” as one of my colleagues describes such a situation, can be a drawn-out, messy and very expensive process. It is also one that may be addressed, at least in part, by a well-thought out and well-drafted shareholders agreement. In putting together such an agreement, the original owners will have to address various governance, distribution and transfer-related topics; they will not be able to foresee every scenario; they will have to negotiate with one another; and they will likely disagree on certain items. The agreement will not be perfect, and they will have to engage tax and other legal counsel to assist them in the process.
However, the original owners must not be deterred by the process. Many problems may be avoided, and their impact on the business and the cost of addressing them (including tax costs) may be significantly reduced, by properly planning for them in advance. It just makes economic sense.