July 31, 2012

Pushing Partner's Buttons in an S Corporation: Pain and Prevention

Stuart L. Pachman

Corporations were originally designed so that large amounts of money could be raised from numerous investors for big projects such as trading companies, canals, and later railroads. Where there are many shareholders and a public market, an unhappy minority shareholder who wants "out" has the ability to sell his or her shares for their market value. By contrast, in the closely held corporation with few shareholders and no public market, there was a time when a minority shareholder subject to rule by the majority had no way out. To remedy this, states amended their corporate laws to provide an avenue of relief, and over the last several decades these "minority oppression" statutes have spawned numerous decisions.

When I first wrote on this subject, the similarity of the personal dynamic between shareholders in a business breakup and participants in a failed marriage was noted. In the intervening years, as minority (and majority) oppression law has developed, the analogy between marital and business "partners" living together in mutual disharmony has expanded. As the relationship breaks down, the not so subtle attempts to inflict pain on one's "partner" begin. It is sometimes difficult to discern who is the oppressor and who is the oppressed.

Illustrative Examples

In the area of corporate law, S corporations, because of the tax driven rules that apply to them, provide a source for the application of pressure points not found in a C corporation. Take the not unusual situation of three individuals, Herman, Wilma, and Herman's loyal and lifelong pal, Buddy. Each owns one-third of the issued and outstanding shares of Passive Income, Inc., an S corporation. Together they constitute its three-person board of directors. Wilma, not as well fixed financially as her co-shareholders, relies on the corporation's distributions as a source of income. Herman wants Wilma out, but she does not want to go. When she refuses his "reasonable" offer for her shares, he decides to put on the squeeze. Although the corporation has annual income of $300,000, Herman and Buddy decide not to declare dividends. Thus Wilma will find herself with a K-1 allocation of $100,000 of income with no cash to pay the resulting federal (and any state) income tax.

The fact that a corporation has profits does not require its directors to distribute them. Whether or not to declare dividends is within the board's discretion in managing the business. Nonetheless, profits may not be arbitrarily withheld. The "power of the court of chancery to order the directors... to make a dividend of unused profits when they improperly refuse to do so is undoubted." In a case not involving an S corporation, the court awarded compensatory and punitive damages against a major shareholder who had suppressed dividends so that he could buy up the shares of other shareholders at low prices. So if Wilma sues, Herman's scheme will probably not succeed. Minority oppression cases expressly hold that one of the remedies available to the court is to direct the declaration of dividends.

If, however, Herman were able to point to some valid business reason for withholding dividends, for example, the need for cash to purchase equipment or to pay a debt to become due, he may succeed. He would also succeed as a practical matter if the court were to compel dividends only in an amount roughly equal to the tax obligations created by the income allocations to the shareholders rather than equal to 100 percent of the corporation's income.

Wilma faces not only the risks (and expenses) attendant on litigation, but a practical problem as well. The tax collector has no interest in her dispute with Herman, and will not sit by until the trial and appeal concludes in a final judgment. Can she hold out that long?

Now put the shoe on the other foot. For whatever reason—either because she disagrees with the corporate decision to acquire Blackacre, or because she needs to convert her stock into spendable cash, or because she believes she is being treated unfairly—Wilma wants out. Herman and Buddy, however, will neither cause the corporation to redeem her shares nor accept her "reasonable" offer to sell. To put the squeeze on them, Wilma threatens to sell her shares to a buyer not qualified to hold shares in an S corporation which would cause loss of the corporation's S status, an undesirable result as far as Herman and Buddy are concerned. She contends her stock is freely tradable property. Herman and Buddy claim that she owes a fiduciary duty to her fellow shareholders preventing her from carrying out her threat.

In Sery v. Federal Business Centers, Inc., the court declined to find that the plaintiffs, by consenting to the S election, had entered into a contract prohibiting them from selling to a non-qualified buyer. It also ruled that the plaintiffs could sell their S corporation shares to a nonqualified buyer if they acted in an economically reasonable manner and if they did not act in bad faith for the primary purpose of injuring their co-shareholders. Thus although Wilma may sell her shares, she is subject to the implied covenant of good faith and fair dealing. She cannot force a buyout by threatening to form a non-qualified entity to which to transfer some or all of her shares; that would clearly demonstrate bad faith.

Even if she were acting in good faith, Wilma has a practical problem. Will she be able to find a buyer, whether or not qualified to hold S corporation shares, which is willing to pay money to become a minority shareholder in a corporation whose shares are closely held?


The lesson from both scenarios is evident. A shareholders or similar type agreement is advisable in any business setting (and a lot easier for a lawyer to discuss with business people than a prenuptial with a couple about to wed). A lawyer, when forming a business entity, just as an official performing a marriage ceremony, has no way to ensure that the parties' current positive personal relationship will endure, but when all of the business principals are on the same side of the table and S status is elected, issues of the nature that confronted Herman and Wilma can be addressed in the corporate documents (the certificate of incorporation, the by-laws, or a shareholders' agreement). Some corporate statutes expressly provide that continuing the corporation's S status is a valid reason for a restricting the alienation of shares that would otherwise be freely tradable.

Among the several protective methods available, one that would protect Herman is a written undertaking by all shareholders to act at all times to maintain the S status of the corporation, including, but not limited to, not selling shares to one not qualified as an S corporation shareholder. To protect Wilma, the corporate documents could require a percentage of its taxable income to be distributed annually (or perhaps quarterly) to provide each shareholder with cash in an amount at least roughly equal to the shareholder's income tax obligations resulting from the corporation's K-1 allocation of income. The parties may wish to provide for exceptions. Whatever the protective method, its choice should be made while the love light shines in the eyes of those about to join in business matrimony.

Stuart L. Pachman

Member, Brach Eichler L.L.C.

Stuart L. Pachman is a member at Brach Eichler L.L.C. in Roseland, New Jersey.