Friday, May 26, 2017
Minority shareholders in a small, closely-held corporation are in a precarious position. They have no control over management of the corporation, and, for example, can’t force dividends to be paid or force a corporate liquidation. Clearly, corporate directors (including those acting as directors) owe a fiduciary duty to the corporation with respect to their actions as directors, and those fiduciary duties apply in the context of directors’ ability to manage the closely-held business within their discretion. However, while corporate directors can generally use their business judgment to operate the business as they deem appropriate, they must manage the business in a manner that is consistent with honesty and good faith toward all of the shareholders – the minority included.
A recent opinion of the Nebraska Court of Appeals involved an allegation of “oppression” of a minority shareholder is a closely-held farming corporation. While the minority shareholder was not able to establish that oppression had occurred, testimony was offered in the case by the corporation’s tax professional that merits a closer look.
In Jones v. McDonald Farms, Inc., 24 Neb. App. 649 (2017), the defendant was incorporated as an S corporation in 1976 by a married couple. The couple had four children – two sons and two daughters. The sons began farming with their parents in the mid-1970s. Upon incorporation, the parents were the majority shareholders and the sons held the minority interests. One of the sons became corporate president when the father resigned in 1989 and the other son became the vice-president. The mother died in 2010 and her corporate stock shares passed equally to all four children. In 2012, the father gifted his stock equally to the sons and, after the gift, the sons each owned 42.875 percent of the corporate stock and the daughters each owned 7.125 percent.
The father died in early 2014 at a time when the corporate assets included 1,100 acres of irrigated farmland and dry cropland. The corporation, since 1991, leased its land to two other corporations, one owned by one son and his wife, and the other corporation owned by the other son and his wife. The land leases were 50/50 crop share leases with each son’s corporation performing all of the farming duties under the leases. In 1993, the corporation converted to a C corporation with corporate employees being paid in-kind commodity wages. For tax planning purposes, corporate net income was kept near $50,000 annually to take advantage of the 15 percent tax rate by timing the purchase of crop inputs, replacing assets and paying in-kind wages. The father and sons did not receive any cash wages, but did receive an amount of commodity wages tied to crop prices and yields – all with an eye to keeping the corporate net income low. Hence, the amount of commodity wages varied widely from year-to-year. The corporation’s CPA testified that he believed the high commodity wages in the later years was appropriate because of the amount of accrued unpaid wages since 1976. The CPA also testified that the corporation was not legally obligated to pay any wages, but that it was merely optional for the corporation to do so.
The corporation’s articles of incorporation required a shareholder to offer their shares to the corporation for purchase at book value before selling, giving or transferring them to anyone else. Shortly after her father died, the plaintiff, one of the daughters, offered to sell her shares to the corporation for $240,650 – the fair market value of the shares based on a December 2010 valuation done for purposes of the mother’s estate. The corporation, in return, offered to buy the shares for $47,503.90, the book value as of December 2011 less $6,000 due to a corporate loss sustained by the plaintiff’s failure to return a form to the local Farm Service Agency office.
The plaintiff sued in early 2013 seeking an accounting, damages for breach of fiduciary duty and conflicting interests, judicial dissolution of the corporation based on oppressive conduct, misapplication and waste of corporate assets and illegal conduct. The trial court denied all of the plaintiff’s claims, finding specifically that the payment of commodity wages and purchase of expensive farm equipment were not unreasonable or inappropriate.
On appeal, the appellate court affirmed. The appellate court, noting that while NE law does provide a remedy to minority shareholders for oppressive conduct, the court stated that the remedy of dissolution and liquidation is so drastic that it can only be invoked with “extreme caution.” The court noted that the plaintiff was essentially challenging the corporation’s tax strategy, and asserting that the corporation should be maximizing its income and paying dividends and the failure to do so constitutes oppressive conduct particularly because, as the plaintiff noted, the corporation had over $13 million in assets and no debt.
The appellate court disagreed with the plaintiff, and made the following specific findings:
- A corporation is not required to pay dividends under state law, and the corporation had a long history of never paying dividends.
- The high level of commodity wages in the later years was not oppressive because it made up for years the shareholders worked without compensation.
- The plaintiff did not have a reasonable expectation of sharing in corporate profits because the plaintiff acquired her stock interest entirely by gift or devise and never committed capital to the corporation.
- Since incorporation in 1976, no minority shareholder had ever been paid profits.
- The payment of commodity wages was not illegal deferred compensation.
- The corporation’s offer to pay book value for the plaintiff’s shares was consistent with the corporate articles of incorporation, and the plaintiff did not challenge the method by which book value was calculated.
- The stock transfer restriction was upheld as enforceable contract.
Tax Planning Concerns
Commodity wages. As the facts of the case indicated, the corporation leased its land to two other corporations, with each of the lessee corporations owned by a son that was a shareholder of the landlord corporation. As noted, those sons were receiving commodity wages from the landlord corporation. Unless the landlord corporation was materially participating in the lease, the income derived under the lease (whether in cash or crop-share) is a rent receivable. Thus, the payment of commodity wages would trigger income to the corporation and payroll taxes to the sons at the time of the transfer of the commodity as a wage. The commodities are rent and not inventory that the corporation raised. While the corporation could pay commodity wages from its inventory (e.g., a crop that the corporation raises), it can’t pay commodity wages with a crop share that is classified as a rent receivable. The outcome is different, however, if the corporation is materially participating under the lease in the production of the commodities. In addition, that material participation must be achieved via the corporation’s employees.
That last point is important. Since material participation must be satisfied by the corporate employees, reasonable compensation must be paid for those services. That compensation will either need to take the form of a landlord’s share of the rent or a portion of the crop that the corporation raised (via material participation under the lease).
As for wages, an appropriate amount must be paid for services rendered. If services are not rendered, no wages should be paid. The point is that wages are not optional. Dividends are optional. However, the facts of the case indicated that the father (while living) and sons had numerous years where they did not receive any wages, with those unpaid wages being made up in later years in the form of high commodity wages. That’s an interesting (and highly relevant) fact from a tax standpoint. There are innumerable court cases addressing unreasonably high compensation (paid in order to lower C corporation income). As a landlord corporation under a crop share arrangement, the corporation provides the land and the tenant provides the services. Landlord services would be minimal. Indeed, in the NE case, the court noted that each son’s corporation performed the farming duties – not the landlord corporation. But, it was the landlord corporation that paid the commodity wages. That could cause the IRS to assert that the compensation was unreasonably high. Alternatively, if the landlord corporation were materially participating under the lease, a question could arise as to whether the 50-50 crop share arrangement sufficiently compensated the corporation for the material services that were rendered.
Another concern with having unpaid wages is the lack of documentation. With documentation, though, the corporation would have a deferred compensation plan, subject to onerous taxes unless payment requirements are strictly satisfied.
Why were wages paid in-kind instead of in cash? For agricultural labor, only cash wages are subject to Social Security tax. Wages paid in-kind to agricultural labor are not subject to FICA tax, FUTA (Federal Unemployment Tax Act) tax, or income tax withholding, but they are subject to income tax. I.R.C. §§3121(a)(8); 3306(b)(11). In 1994, an IRS Task Force produced guidelines that set forth several factors as relevant in determining when a particular in-kind payment qualifies for the exemption. To the IRS, the payment of at least some cash wages is important. That’s another area of concern with the wage arrangement of the corporation in the NE case.
A drawback of paying wages-in kind is that they don’t generate W-2 wages for purposes of the domestic production activities deduction of I.R.C. §199. They are also not considered wages for purposes of determining the amount of earnings in retirement.
Other tax issues. Another question concerns the value of the corporate assets. The court noted that the corporation had $13 million in assets. Depending on the mix of corporate assets (land and non-real estate assets), the corporation might have triggered the personal holding company (PHC) tax. I.R.C. §541. If a C corporation has too much investment income, the PHC tax will apply. When more than a single entity is utilized, the landholding C corporation will receive the bulk, if not all, of its income from leasing the land to the production entity or entities. If the lease is not structured properly, the income under the lease can be construed as passive investment income which may trigger application of the personal holding company tax. The personal holding company tax is levied at a 20 percent rate on undistributed personal holding company income, and serves as a “penalty tax” in addition to the corporation's income tax that is normally owed.
To be a personal holding company, two tests must be met. The first test is an ownership test, and is satisfied if five or fewer people own more than 50 percent of the corporate stock during the last half of the taxable year. Most farming and ranching operations automatically meet this test, and it was satisfied in the NE case. The second test is an income test and is satisfied if 60 percent or more of the corporation's adjusted gross income (gross receipts reduced by production costs) comes from passive investment sources. Rental income is included in adjusted ordinary gross income unless adjusted rental income is at least 50 percent of adjusted ordinary gross income, and dividends for the taxable year equal or exceed the amount (if any) by which the corporation's non-rent personal holding company income for that year exceeds 10 percent of its ordinary gross income. In other words, if the mixture of rental income and other passive income sources exceed 10 percent and the rental income exceeds 50 percent, the personal holding company tax could be triggered. Thus, farming and ranching corporations engaged predominantly in rental activity may escape application of the personal holding company tax. But if the corporation's non-rent personal holding company income (dividends, interest, royalties and annuities) is substantial, the corporation must make taxable dividend distributions to avoid imposition of the personal holding company tax. Thus, for corporations owning agricultural land that is cash rented out and the corporation's only passive income source is cash rent, there is no personal holding company tax problem. There is not enough detail provided by the NE court to make this determination.
Another possible complication is the accumulated earnings (AE) tax. I.R.C. §531. The AE tax applies only to amounts unreasonably accumulated during the taxable year. Thus, the real issue is the extent to which corporate earnings and profits can accumulate before triggering application of the accumulated earnings tax. All corporations are permitted to accumulate earnings and profits of $250,000 without imposition of the tax except for service corporations (fields of health, law, engineering, architecture, accounting, actuarial science, performing arts and consulting) where the amount is $150,000. The accumulated earnings tax rate for tax years after 2012 is 20 percent. However, not every corporation that exceeds $250,000 (or $150,000) of accumulated earnings and profits will trigger application of the accumulated earnings tax. The tax applies only if a particular corporation has accumulated more than $250,000 (or $150,000) in earnings and profits and the accumulation is beyond the reasonable needs of the business. In the NE case, the corporation was deliberately leaving $50,000 of taxable income to be taxed. If the corporation has a lot of investment assets, the IRS could seemingly make a strong argument that the corporation is subject to the AE tax. In a recent IRS Chief Counsel’s Advice (CCA), the IRS noted that the corporation could be held responsible for the AE tax without any investment assets. I blogged on the CCA and its implications in early January. http://lawprofessors.typepad.com/agriculturallaw/2017/01/c-corporation-penalty-taxes-time-to-dust-off-and-review.html
There are other comments that could be made about the legal issues involving minority shareholder oppression, but today’s post is long enough already. While the corporation and its majority shareholders prevailed in the NE case, care should always be taken by tax professionals when they provide testimony in cases that aren’t purely tax-related. Some things, in that context, probably shouldn’t be commented on.