Using Selected Tax Principles to Determine Oppressive Conduct in Minority Shareholder Suits

Minority shareholder disputes continue to plague owners of the privately-owned corporation. The exclusion from a role in management, the improper use of corporate assets, the taking of unreasonable compensation, of earnings without payment of dividends are typical of the minority shareholder. In such circumstances, many states provide the remedy of involuntary corporate dissolution are shareholder buy-out on the grounds of illegal, fraudulent, or oppressive conduct. In addition, a growing number of states have recognized a direct action for a breach of fiduciary duty among shareholders of the private company. Conduct characterized as a breach of fiduciary duty, or as an "illegal," "fraudulent," or "oppressive" action justifying corporate dissolution, is frequently the same type of behavior that results in income tax deficiencies. Strategies to usurp corporate profits from ones business associates frequently lead to significant adjustments by the Service as well. Complaints of underreporting income, the payment of excessive salary to specified shareholder-employees, the failure to declare dividends, the failure to keep proper books and records, and the personal use of exploitation of corporate assets are echoed in case after case involving shareholder disputes. Although in an abstract discussion it appears obvious that such issues are also the focal point of considerable tax litigation, in practice, a corporate lawyer may well overlook quite significant tax issues presented by the facts while focusing on the underlying shareholder dispute that leads the client to his or her door. This article highlights the recent cases in which the plaintiffs allegations of breach of fiduciary duty or "illegal" or "oppressive" conduct justifying corporate dissolution involve claims that the defendant has underreported income, failed to comply with payroll tax rules, or has otherwise engaged in conduct which causes or could cause a substantial tax penalty. The Article also reviews the recent cases in which majority owners have sued minority shareholders for a breach of fiduciary duty where the minority shareholders have engaged in conduct or have threatened to engage in conduct which places the company in a position of violating tax rules and/or incurring tax deficiencies. Conversely, the Article suggests that objective standards developed under tax law may be useful in tax-sensitive oppression cases by providing judicial guidelines for determining when conduct breaches fiduciary duties. Objective standards of reasonableness for developing compensation and dividend policies have been well-developed under tax law, and could be creatively adapted for use as guidelines in the determination of whether a shareholders conduct in "oppressive." Indeed, the objective standards developed under tax law on reasonable compensation, dividend levels, and arms-length pricing provide far more certainty and guidance to the business community than the vague judicial tests currently employed for determining "oppressive" conduct, which rest on fairness in the circumstances and/or on the minority's reasonable expectations. Both the fiduciary duty cases and dissolution controversies underscore the need for proactive business and tax planning to secure by contract the minority's agreement to comport with the tax compliance objectives established by the majority. Both lines of cases illustrate the value of developing exit or buy-out provisions and arbitration provisions for private companies with minority shareholders. In light of the tax-sensitive oppression cases reviewed, the Article urges practitioners to encourage clients to adopt sound systems for bookkeeping as well as internal controls, and to document the business reasons for salary and dividend levels. Majority owners of private companies may become vulnerable to attack by the minority shareholders and the Service when internal controls are lacking, record keeping is sloppy, and salary and dividend policies are unsupported by documentation establishing the business reasons for such purposes. Documentation of sound business purposes for compensation and dividend purposes, and for pricing regarding transactions between the corporation and the shareholder, may prove helpful not only in a controversy before the Service, but also in a civil dispute between majority and minority shareholders of a private company. Finally, the Article suggests that as a policy matter, dissolution statutes themselves could be improved by identifying the factors that are indicative of oppressive conduct, such as the payment of excessive compensation, failure to pay dividends, unreasonable accumulation of earnings, underreporting of income, misuse of corporate assets, and lack of arms-length pricing. The statutes could borrow language from a rich body of well-developed objective standards developed under tax case law and regulations to establish criteria for determining reasonable compensation, reasonable dividend levels, appropriate record-keeping requirements, and arms-length pricing for the use of property or the provision of services by related parties.