Shareholders held hostage

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Limited liability companies and S corporations are popular ways to do business in Iowa. Income of both S corporations and LLCs is only tax once; C corporations, in contrast, can be taxed twice. 

Yet the single-tax format can cause problems.  The single tax is achieved by having the business income taxed on the returns of their owners, rather than to the business itself.  Business income taxed on the return can be distributed to owners without a second tax. Most LLCs and S corporations distribute some or all of their earnings - at least enough to let their owners pay the tax on the business income.  But what if they don't?

That problem came up in a case decided yesterday by the Iowa Court of Appeals. An S corporation was owned by a family. When the mother died in 2006, her son Joseph exercised an option to purchase her shares at a formula price. The mother's Estate and Joseph couldn't agree on how the formula should work (a good story in itself), and it's taken three years (so far) to sort that out. In the meantime, the Estate has still owned the shares, and the company has remained profitable. That means the Estate has had to pay tax on its share of corporate income. 

Joseph, however, had the S corporation stop making distributions. 

So - the Estate had to pay tax on the earnings, even though it wasn't receiving any distributions.  Meanwhile, the formula price was fixed at the date of death, so the Estate wasn't getting any benefit from the income that it was paying the tax on. Or at least that's the way Joseph wanted it to work. This had the perhaps intended effect of putting pressure on the estate to settle.

The Court of Appeals of Iowa didn't let that stand.  While it sided with Joseph on how the formula should work, it wouldn't let him hold the distributions hostage (my emphasis):

The Estate specifically alleged that Joseph's decision to have the corporation stop making distributions sufficient to cover the ongoing tax liabilities breached that duty. Joseph acknowledged in his testimony that he caused DLDC to cease paying distributions. We conclude that this conduct was in bad faith, since it had the purpose and effect of forcing the Estate to bear the tax liabilities while Joseph received the corresponding profits on the Estate's shares, with no apparent justification...

Joseph engaged in bad faith and oppressive conduct, and breached the covenant of good faith and fair dealing in the buy-sell agreement, by discontinuing the longstanding practice of paying dividends during the pendency of this dispute. We agree with the Estate that the federal and state income taxes it was forced to pay on post-July 2006 profits without any distributions to pay them should be added to the compensation it receives from Joseph for its shares.

Unless this result is reversed by the Iowa Supreme Court, this case gives hope to minority owners of profitable LLCs and S corporations.  If a majority owner withholds income tax payment distributions, perhaps to force a sale, Iowa courts could well step in on behalf of the minority owners to force a payout.

But it would have been best to avoid this problem by including in the buy-sell option agreement a clause requiring a business to make distributions to cover taxes until the sale closes.

Note: Hat-tip to IowaBiz.com contributor Christine Branstad for her Twitter link to the case.