Old Dog, New Tricks?
It’s a concern for every new investor in a closely held business: will the founding owners continue to operate the business as they always have, or will they recognize that they now have new co-owners to whom they owe a fiduciary duty, and on whom they made be dependent for funding or services, and will this recognition inform their actions with respect to the business and guide their relationship with the new investors?
Because of this concern, the new investor will insist that the owners enter into a shareholders’ or partnership agreement that includes various provisions that seek to protect the new owners’ rights, and to limit the original owners’ ability to ignore those rights and thereby compromise the economic benefits sought by the new investors.
Unfortunately, at least from the perspective of the new investor, it is not unusual for the founder, notwithstanding any shareholders’ or partnership agreement, to “forget” that he has others to whom he has to report. While such “forgetfulness” will strain the relationship among the owners of any business entity, it can be especially stress-inducing in the context of a pass-through entity like a partnership or an S corporation, the income of which is taxed to its owners without regard to any owner’s ability to influence or control the entity’s activities.
Yet Another Example
In a recent case before the Tax Court, the taxpayer tried to convince the Court that she should not be required to include her share of S corporation income in her gross income because the controlling shareholder had effectively prevented her from enjoying the beneficial ownership of her shares.
Corp was created by Founder to operate a diagnostic laboratory. Founder approached Taxpayer – who worked with Merchant Bank (“MB”) – to ask whether she would consider getting involved in Corp. Taxpayer and Founder discussed certain issues that Corp was facing, including its lack of a solid financial infrastructure.
Corp eventually entered into a consulting agreement with MB, under which MB would assist Corp with settling existing liabilities, diversifying the business, and implementing a financial infrastructure. In consideration for these services, Corp would pay MB a fixed monthly fee.
As part of this arrangement, Founder’s ownership of Corp was reduced to 50%, and members of MB or their designees (MB shareholders, including Taxpayer) acquired ownership of the other 50%.
The shareholders of Corp executed a Shareholders’ Agreement. The Agreement named various individuals, including Founder and Taxpayer, as officers of Corp. The board of directors of Corp consisted of its officers, including Taxpayer. The Shareholders’ Agreement stated that “[a]ll matters relating to the management of [Corp’s] business and operations of any kind or nature whatsoever shall be approved by a majority vote of [Corp’s] Board of Directors.” The board of directors, however, met only once after executing the Shareholders’ Agreement.
The Shareholders’ Agreement further stated:
The timing and amount of any distributions of net profits or cash flow from [Corp’s] operations or otherwise (the “Distributions”) to be made by [Corp] to the Shareholders hereunder shall be approved by the Board of Directors . . . . All Distributions shall be made by [Corp] to the Shareholders pari passu in accordance with their proportionate Share ownership hereunder.
In addition, the Agreement implemented a new payment approval procedure for Corp, stating:
The authorizing resolution to be delivered to the bank or other depository of funds of [Corp] shall provide that any officer signing singly may execute all checks or drafts of [Corp] in an amount up to $100,000.00, and two (2) persons consisting of [Founder] and one (1) member of the MB shareholders, shall be authorized as joint signatories in respect of all checks or drafts on behalf of the [Corp] in excess of $100,000.00.
Nevertheless, Corp frequently made payments in excess of $100,000 that were not authorized in conformity with the Shareholders’ Agreement.
Finally, the Agreement gave the shareholders the right to inspect and copy all books and records of Corp. At the beginning of MB’s relationship with Corp, Corp’s CFO distributed copies of monthly financial statements to representatives of the MB shareholders.
One concern raised by Corp’s financial statements involved a loan from Founder to Corp close to the time of its organization. General ledgers made available to the MB shareholders, and reviewed as part of MB’s due diligence, showed a loan balance in excess of $7 million. Money paid by Corp on Founder’s behalf, including personal expenses, was charged against this loan, reducing the loan balance, and interest on the loan was paid to Founder monthly.
An audit of Corp’s financial statements found that payments made from Corp to Founder were recorded on the loan payable’s general ledger account, and the loan appeared as a “Note Payable” on the audited financial statements, and appeared as “Liabilities” on Corp’s Federal income tax returns. However, no “Loan from Shareholder” was reflected on the Schedules L of Corp’s Federal income tax returns on Form 1120S.
As Founder’s relationship with MB and the MB shareholders began to deteriorate, Taxpayer approached Founder concerning certain Corp expenses that Taxpayer believed were personal and unrelated to Corp’s business.
At that point, Founder no longer permitted MB and the MB shareholders to enter Corp’s premises, and he instructed Corp’s employees to stop providing financial information to them. Corp also stopped paying MB for its consulting services.
Unbeknownst to the MB shareholders, Founder also filed a complaint seeking judgment against Corp for the loans he claimed to have made to Corp over the course of many years. Founder served the complaint on the comptroller of Corp, Corp did not defend the lawsuit, and a default judgment was entered against Corp.
MB sued Founder for breach of the consulting agreement and failure to pay consulting fees. In reaction to this lawsuit, Founder filed for chapter 11 bankruptcy.
The bankruptcy court appointed a forensic accountant to investigate Corp’s business operations. The accountant’s report determined that the transfers of funds to Founder disputed by MB and the MB shareholders were recorded on the books by Corp as loan repayments. The report also described the default judgment that Founder had obtained against Corp.
As a result of the above findings, the bankruptcy court appointed a trustee as a financial overseer of Founder’s activities at Corp. The trustee was responsible for evaluating the financial status of Corp, taking financial control, and reporting his findings to the bankruptcy court. During the trustee’s time with Corp, payments of expenses or transfers of funds could not be accomplished without his approval. Additionally, the trustee provided Corp’s shareholders with monthly financial reports.
The Tax Returns
When Taxpayer filed her Forms 1040, U.S. Individual Income Tax Return, for the taxable years at issue, she attached to the return a Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request. The Form 8082 included the following statement pertaining to Taxpayer’s ownership interest in Corp:
[Corp] has initiated litigation against the [T]axpayer retroactively contesting [T]axpayer’s ownership interest. The entity and certain shareholders have prevented [T]axpayer from exercising [her] shareholder rights including: sale of shares, voting on business matters, exercising dominion and control of the ownership interest, or enjoying any economic benefits or other ownership rights. The referenced Schedule K-1 is inconsistent with the entity’s contention that [T]axpayer is not entitled to any ownership interest. Therefore until legal ownership is resolved by the court, it was improper for the controlling shareholders to issue a Schedule K-1 to [T]axpayer, and those amounts are not reported in this return.
The issue for decision before the Tax Court was whether Taxpayer was a shareholder of Corp during the years in issue and was, therefore, liable for tax on her pro rata share of Corp’s income for the taxable years at issue.
The Code provides that the shareholders of an S corporation are required to take into account their pro rata shares of the S corporation’s income, loss, deductions, and credits for the S corporation’s taxable year ending with or within the shareholders’ taxable year. An S corporation’s shareholders must take into account the corporation’s income regardless of whether any income is distributed to the shareholder.
The Court stated that, in determining stock ownership for Federal income tax purposes, it must look to the beneficial ownership of shares, not to mere legal title. Cases concluding that a shareholder did not have beneficial ownership, the Court continued, have considered both agreements between shareholders that effectively eliminated ownership, and provisions in the corporation’s governing articles affecting ownership rights.
Mere interference, the Court observed, with a “shareholder’s participation in the corporation as a result of a poor relationship between the shareholders * * * does not amount to a deprivation of the economic benefit of the shares.”
Taxpayer contended that while she was issued Corp shares, the removal of her power to exercise shareholder rights, as well as the actions of Founder, “removed” the beneficial ownership of her shares; therefore, Taxpayer asserted, she was not required to include in gross income her “pro rata share” of Corp’s income.
The Court noted, however, that Taxpayer identified no agreement, nor any provisions in Corp’s governing articles, removing her beneficial ownership.
Moreover, Taxpayer identified no authority supporting her position that a violation of a shareholders’ agreement could deprive shareholders of the beneficial ownership of their shares.
Further, Taxpayer cited no authority that allowed a shareholder to exclude her share of an S corporation’s income because of poor relationships with other shareholders.
In the absence of an agreement passing Taxpayer’s rights to her stock to another shareholder, a poor relationship between shareholders did not deprive Taxpayer of the economic benefit of her shares. Indeed, the Court pointed out, Taxpayer ultimately sold her shares for valuable consideration.
The Court held that because Taxpayer remained a shareholder of Corp for the taxable years at issue, she had to include in gross income her pro rata share of Corp’s income for those years.
The Taxpayer was hardly the first to argue that she was not liable for the tax on her share of S corporation income because she was improperly denied the beneficial ownership of shares in the corporation, notwithstanding her record ownership.
As in other cases, the Tax Court rejected Taxpayer’s position, noting that when a controlling 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. Thus, the shareholder is not relieved from reporting her share of the S corporation’s income on her tax return.
A minority owner in any pass-through entity must appreciate the risk that she may be denied the opportunity to participate in the business in any meaningful way, that she may be denied any opportunity for gainful employment in the business, and that she may not receive any distributions from the entity.
The minority owner must also recognize that even when she is fortunate to be party to an agreement with the other owners that provides for mandatory tax distributions and for super-majority voting for certain decisions, such an agreement is meaningless in the face of a majority’s disregard of its terms unless the minority owner actually seeks to enforce the agreement.
In the face of a stubborn or determined founder, a minority owner must be prepared to act fairly quickly to protect herself, or “accept” the economic and tax consequences of having to report her share of the entity’s net income on her tax return. In that case, the minority owner must look to her other assets to provide the cash necessary to satisfy the resulting tax liabilities. This can turn into an expensive proposition.