Proudly Serving Atlanta, GA

Minority Shareholders: Withholding of Dividends and the Tax Burden it Creates

WITHHOLDING OF DIVIDENDS AND THE TAX BURDEN IT CREATES

Throughout this series we will detail some of the common methods that majority shareholders use to destroy a minority shareholder's value in the company and what rights a minority shareholder has when this happens. In this post we address a majority shareholder's attempt to "squeeze" a minority shareholder out of the company by retaining earnings in the company rather than paying dividends.

As stated above and referenced in the last post in this series Post #2: Wrongful Termination & tortious Interference with Business Relations, once a majority shareholder has terminated a minority shareholder's employment in the company, it can then begin to force the minority shareholder out of the company by refusing to declare dividends the minority shareholder in an attempt to "squeeze" them out of the company. As alluded to earlier, one of the problems for minority shareholders in a corporation is that they lack the power to declare or not declare dividends. Instead, this voting power rests with the majority shareholder. A majority shareholder can easily abuse this power in an attempt to force the minority shareholder out of the company.

This method can be effectively used in a Subchapter S corporation or LLC. For those who have never heard of a Subchapter S corporation, or any other types of corporation for that matter, here is a quick summary. Election of Subchapter S status allows a corporation to pass its tax liability to each shareholder proportionate to his share interest in the company. The simple way of explaining this benefit is that this can result in a type of tax break for the shareholders of the company if their individual tax rates are lower than the corporate tax rate. Rather than be taxed at the higher corporate rate, shareholders can tax their profits at the lower individual rate, saving money. This avoids what is known as "double taxation." Obviously as individual tax rates rise this may not be profitable, and there are other factors to consider, but the decision to enter or not enter into Subchapter S status is beyond the scope of this article.

If no dividends or other distributions are made to the minority shareholder in a Subchapter S corporation or LLC, he or she is nevertheless required to pay taxes on the corporate income despite not receiving any of the income to help meet the tax obligation. Thus, the squeeze-out technique has been recognized in Georgia where a majority shareholder attempts to force a minority shareholder out of the company by withholding dividends without a legitimate corporate purpose.

As majority shareholders can control the decisions to declare dividends and assign salaries to corporate employees, the majority shareholders can freeze all corporate income while continuing to pay themselves salaries and other benefits and not paying the minority shareholder a salary or benefits. Once the minority shareholder has been excluded as an employee, the majority shareholders may choose to award themselves bonuses and higher salaries, diverting company funds that would usually be dividends into their own pockets.[1] Once the minority shareholder starts to feel the burden of the tax obligation, but is not receiving any money from the corporation, his or her value in the company becomes essentially worthless at best and a huge detriment at worst. The majority shareholder will then try to buy, or "squeeze-out," the minority shareholder at a fraction of what his or her shares are actually worth.

Fortunately, Georgia courts have identified these actions as a breach of fiduciary duty to the minority shareholder. A majority shareholder is required to deal in good faith with minority shareholders and protect their interests. Georgia case law states,

[g]ood faith is not just a question of what is proper for the corporation. It also requires that the stockholders be treated fairly and that their investments be protected. In close corporations, minority stockholders may easily be reduced to relative insignificance and their investment rendered captive, because ordinarily there is no market for minority stock in a close corporation and a minority stockholder cannot easily liquidate his investment for its true value... The control and management of corporations is always dictated by the majority...The minority stockholder has an interest in the liquidity of the corporation. He looks to the earned surplus for payment of dividends.[2]

The Georgia Supreme Court went on to state that because the minority shareholder's "own interests [were] depreciated and used to render him ineffective and 'freeze" his investment,' such action demonstrated a lack of good faith. Yet another method by which majority shareholders can breach their fiduciary duty to minority shareholders is to increase the number of shares available in an effort to diminish the minority shareholder's ownership interest and share value.

Now, it is important to recognize that not all actions by the majority shareholder that happen to disadvantage the minority shareholder are to be considered breaches of fiduciary duty. Georgia law states that a "claim for breach of fiduciary duty requires proof of three elements: (1) the existence of a fiduciary duty; (2) breach of that duty; and (3) damage proximately caused by the breach."[3] In determining whether there has been a breach of the duty by the board or majority shareholder, Georgia law employs what is known as the "business judgment rule" to determine whether or not a majority shareholder has breached his or her duty. Georgia law demands that

corporate officers and directors discharge their duties in good faith and with the care of an ordinarily prudent person in a like position.[4] In determining whether a corporate officer has fulfilled his or her statutory duty, Georgia courts apply the business judgment rule. The business judgment rule affords an officer the presumption that he or she acted in good faith, and absolves the officer of personal liability unless it is established that he or she engaged in fraud, bad faith or an abuse of discretion: The business judgment rule protects ... officers from liability when they make good faith business decisions in an informed and deliberate manner. The presumption is that they have acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company. Unless this presumption is rebutted, they cannot be held personally liable for managerial decisions. However, officers may be held liable where they engage in fraud, bad faith, or an abuse of discretion.[5]

In simpler language, this means that a judge will not find the withholding of dividends by the board of directors automatically wrongful, but will instead look to whether they had adequate reasons for doing so. This gives the board wide discretion to choose to not declare dividends, as long as its decision is not arbitrary, fraudulent, or in bad faith.[6] A company may decide to withhold dividends for several valid reasons, but where there is evidence of a history of dividends being issued prior to the termination of the minority shareholder in addition to large bonuses and compensation to officers in lieu of dividends, a court may likely find that there has been a breach of fiduciary duty and a failure to meet the requirements of the business judgment rule. A court will examine several factors to determine whether a board is justified in not declaring dividends, including the "corporation's present and prospective financial needs," "special interests of the majority not shared by the minority," and the "amount of surplus, the ratio of current assets to current liabilities, the amount of working capital, business prospects, [and] the need for expansion."[7]

A healthy understanding of your rights as a minority shareholder is vital to your, and your company's, continued success and profitability. In order to avoid the situation detailed above, it is important to keep abreast of your company's organizational and financial information. As majority shareholders attempt to squeeze you out of the company, they will try to keep this information from you, a situation that we will cover in the next post.

[1] F. Hodge O'Neal & Robert B. Thompson, Oppression of Minority Shareholders and LLC Members, § 3:7 (rev. 2nd ed. 2004).

[2] Comolli v. Comolli, 241 Ga. 471, 474-75, 246 S.E.2d 278, 280-81 (1978).

[3] St. James Entm't LLC v. Crofts, 837 F. Supp. 2d 1283, 1291 (N.D. Ga. 2011).

[4] OCGA §§ 14-2-83; 14-2-842(a).

(a) A director shall discharge his duties as a director, including his duties as a member of a committee:

(1) In a manner he believes in good faith to be in the best interests of the corporation; and

(2) With the care an ordinarily prudent person in a like position would exercise under similar circumstances.

(b) In discharging his duties a director is entitled to rely on information, opinions, reports, or statements, including financial statements and other financial data, if prepared or presented by:

(1) One or more officers or employees of the corporation whom the director reasonably believes to be reliable and competent in the matters presented;

(2) Legal counsel, public accountants, investment bankers, or other persons as to matters the director reasonably believes are within the person's professional or expert competence; or

(3) A committee of the board of directors of which he is not a member if the director reasonably believes the committee merits confidence.

(c) In the instances described in subsection (b) of this Code section, a director is not entitled to rely if he has knowledge concerning the matter in question that makes reliance otherwise permitted by subsection (b) of this Code section unwarranted.

(d) A director is not liable to the corporation or to its shareholders for any action taken as a director, or any failure to take any action, if he performed the duties of his office in compliance with this Code section. O.C.G.A. § 14-2-830.

[5] Brock Built, LLC v. Blake, 300 Ga. App. 816, 821-22, 686 S.E.2d 425, 430-31 (2009) (citing TSG Water Resources v. D'Alba & Donovan Certified Public Accountants, 260 Fed.Appx. 191, 197(IV)(A) (11th Cir.2007)).

[6] F. Hodge O'Neal & Robert B. Thompson, Oppression of Minority Shareholders and LLC Members, § 3:5 (rev. 2nd ed. 2004).

[7] F. Hodge O'Neal & Robert B. Thompson, Oppression of Minority Shareholders and LLC Members, § 3:5 (rev. 2nd ed. 2004).

Categories: