By Gerald P. Burleson, Member of the California Bar, and Dylan Contreras, J.D., 2019, California Western School of Law, and 2019 candidate for the California Bar
© 2019 by Gerald P. Burleson, all rights reserved
An S corporation is a corporation that has made an election under Subchapter S of the Internal Revenue Code to pass its federal tax liability through to its shareholders. This means that shareholders are required to report the part of the S Corporation’s income and losses attributable to their shares of stock on their personal tax returns and pay tax on it at their individual income tax rates. Since it was the S Corporation that actually received the income, frequently such a corporation will pay a dividend to ensure that its shareholders have the funds to pay their tax liability arising from the income tax liability that was passed through to them, but there is no legal requirement that it do so.
When an S Corporation does not make such a distribution, its shareholders are forced to use their own funds to pay their share of the corporation’s pass-through tax liability. In such a situation, the shareholders may find their shares have become more of a financial liability than an asset. The result, particularly where a shareholder’s personal funds are limited, can be that the shareholder is forced to sell his or her shares back to the corporation or to the controlling shareholder at a knocked-down price.
Some majority shareholders, recognizing this peril, use it to their advantage by nixing distributions with the intent of squeezing out the minority shareholders, and to enable them to purchase minority shares at a bargain price. As there is no legal requirement that a corporation distribute dividends to its shareholders, a majority shareholder may even think that what he or she is doing is perfectly legal. However, the courts have recognized this tactic as shareholder oppression where the failure to distribute amounts to (1) “a violation of the reasonable expectations of the minority” or (2) “a visible departure from the standards of fair dealing”.
Perhaps the leading authority on this issue is the unreported Delaware Chancery court opinion of Litle v Waters (1992). In that case, the plaintiff was a minority shareholder of an S Corporation owning one-third (1/3) of the outstanding stock. The defendant was the majority stockholder, who owned the remaining two-thirds (2/3) of the outstanding stock. Litle alleged that Waters had agreed to make corporate distributions so that Litle could pay for his share of the corporation’s pass-through tax liability. The company was extremely successful, ultimately resulting in a $560,000 tax liability to Litle. However, Waters refused to authorize a distribution and Litle ended up having to drain his personal finances to settle his personal tax liability arising from the S corporation’s income tax liability that was passed through to him. The court determined that it was reasonable to believe that when Waters and Litle entered into their joint ventures, neither expected the other to use their power to make the shares a liability when the company was making money. It was noted that the company was rich with cash and that the only ostensible reason the company did not pay dividends was to aid Waters to effectuate a squeeze out of Litle. This amounted to a violation of the reasonable expectations of Litle as the minority shareholder and was therefore oppressive.
The court also determined that the conduct of Waters in attempting to squeeze out Litle by failing to pay a dividend, when the company seemed able to pay dividends, was a visible departure from the standards of fair dealing and fair play. As such, the court found that Waters’ conduct also amounted to oppression under the second definition.
The application of the common law doctrine of shareholder oppression in this context has not been fully tested in California. Nevertheless, California courts have often turned to Delaware law for guidance on corporate legal issues, and the case of Litle v Waters is likely to remain instructive.
Moreover, a minority shareholder who has suffered an attempted squeeze out by the controlling shareholders of a corporation may find additional relief in statute. Directors owe fiduciary duties to all shareholders under California Corporations Code §309, including a duty to act with honesty, loyalty, and good faith. These fiduciary duties also apply to shareholders who have a majority interest, as such interest inherently gives them control of the company, per Stephenson v. Drever (1997) 16 Cal. 4th 1167 and Neubauer v. Goldfarb (2003) 133 Cal. Rptr.2d 218.
In the unpublished California Court of Appeal case of Arnold v Scoma (2006), the directors and majority shareholder refused to distribute Arnold’s share of net income, despite there being a written contract evidencing such an agreement. Arnold further alleged that the S Corporation’s refusal to distribute was intended to pressure her into selling her shares back to the corporation or the majority shareholder at a low price. The court held in Arnold’s favor, finding that although corporations are not generally required to distribute dividends to their shareholders, the circumstances in this case may have warranted such a duty. Factors influencing this decision were the allegations of oppression, conflict of interest, and an attempt on the part of the defendants to pressure Arnold to relinquish her interest in the corporation.
Where a minority shareholder is being squeezed out of an S Corporation in California by the withholding of distributions, they may well be entitled to sue for relief.