Stock Sales and Employee-Minority Shareholders: What Does It Take to Make a Deal?
June 03, 2019
If you’ve been representing closely held businesses long enough, then the “conversation transcribed” below should sound familiar to you.
I have had several versions of this exchange in the last few months.[i] The common theme? The risk that the IRS may not accept one or more steps in the transaction at their “face value,” and that it may seek to give tax effect to the larger transaction (of which these steps are a part) in accordance with what the IRS believes is its true nature.
It is a basic precept of the tax law that the substance of a transaction, rather than its form, should determine its tax consequences when the form of the transaction does not coincide with its economic reality.
This substance-over-form argument is a powerful tool in the hands of the IRS. It can also be very frustrating for a business owner who genuinely believes that they have a bona fide, non-tax reason for the transaction structure chosen.
In the Present
The sole owner of a successful business has an issue they want to discuss with their attorney.
Owner: I have this really great employee that I want to reward. Any ideas?
Adviser: I know you already pay a more-than-decent salary. What about a generous annual bonus?
Owner: Already doing that.
Adviser: Is the bonus discretionary with you, or is it somehow tied to performance and a formula?
Owner: I decide whether it is paid and how much. I always pay it before the year-end.[ii]
Adviser: You know, if you removed the discretionary aspect, and gave this employee something “measurable,” you may provide them with a greater incentive to work hard and to reach whatever targets you set for them. Make the obvious more tangible or certain for them: if the business does well, they will do well.
Owner: What about giving the employee a piece of the company?
Adviser: Hold on a minute. First, that’s not what I’m suggesting. Second, have they asked for that?
Owner: No. Not really. But I’m sure they’d appreciate it.
Adviser: So would I. Would they pay for the stock?
Owner: They can’t afford to do that.
Advisor: OK. What if you sold it to them at a discount? Would you consider accepting a promissory note from them? Give them time to pay it off? The bargain element would be taxable to them as compensation . . . [iii]
Owner: Actually, I was thinking that I would just gift it to them. Can’t I do that? I recall you telling me that the gift tax exemption was pretty high these days.[iv]
Adviser: This is your employee – actually, your company’s employee. We’re not talking about a family member or friend here. I wouldn’t exhaust my exemption amount on someone who may quit next year, and whom I may have to buy out.
Your relationship is strictly of a business nature, right? Under those circumstances, the IRS is likely to treat as compensation any transfer of property you make to them. [v]
That means ordinary income to them. It also triggers employment taxes. How will you and they pay those taxes?
Owner: How will the IRS even know . . . ?[vi]
Adviser: Please, don’t get me started. Let’s not have this discussion again.
Owner: Can I pay them a bonus for the taxes?
Adviser: A “gross-up?” Yes, but this is going to turn into an expensive proposition for you. That bonus would, itself, be taxable. Do I have to remind you that the employer is responsible for its share of employment taxes?
In any case, I have a more fundamental issue for you. Why would you bring in a minority shareholder, anyway? State law affords them many rights, and imposes certain fiduciary duties on you as the controlling shareholder.
Owner: Oh, now you’re sounding like a lawyer.
Adviser: Well, that’s probably because I am. Sometimes, you even pay me to tell you these things before you go ahead and do something you’ll regret.
Do you think your minority shareholder is going to like the idea of the business’s paying for your clubs, your vacations, the restaurants, the cars, your spouse’s pension plan – still coming in once a month, I gather? – your niece’s tuition, your father’s and your children’s no-show jobs . . . ?
Owner: C’mon, everyone does that.
Adviser: Remember when you entertained that unsolicited offer for the business a few years back? Hmm? You handed over all that information to the prospective buyer’s accountants – thankfully, only after I got wind of what you were doing and prepared a non-disclosure agreement – and they came back with all of the so-called “add-backs”?
Well, your key employee-minority shareholder is going to be questioning those same items, among other things, including your obsession with golf. Don’t you work anymore?
Owner: Well, I need to keep this employee, which means I need to keep them happy. Everyone has their price.
Adviser: I won’t comment on your last statement.
Look, you’ve been talking about selling the business in the next few years, right?
Owner: Sure. That’s exactly why I need to keep this employee – to get me to the finish line.
Adviser (under his breath): And to the golf course.
Owner: What was that?
Adviser: Nothing, just thinking aloud – we need to chart a course. OK. How about a change-in-control payment, one that’s based upon a percentage of the net sale proceeds?
Owner: I can do that?
Adviser: Sure you can. In that way, you give the employee a chance at sharing in the value of the business – at the same time you liquidate your investment – without making them an owner. Remember that discussion we had about “phantom stock”? OK. It’s something like that. You can even require that the employee remain with the business until the sale occurs in order for them to benefit from the sale. If they leave before then, for any reason, they won’t be entitled to any of the proceeds.
Owner: I think I recall this conversation. Something about “vesting,” right? That’s harsh, though, and I don’t want them to think that I can pull the rug out from under them just before a sale.[vii]
Adviser: I’m not suggesting that. Look, I gave you a simple illustration of the concept. You can tailor it to satisfy whatever terms you and your key employee decide upon.[viii] My point is that you can protect yourself.
Owner: Will this payment be taxed as capital gain to the employee?
Adviser: No, it will be taxed as ordinary compensation income, and the company should be entitled to a deduction for the payment.[ix] Think of it as a performance-based bonus – a “thank you” for getting you to your goal.
Owner: Ordinary income? They won’t have anything left after taxes. Can I gross them up, pay them more so they end up where they would’ve been if they had capital gain?
Adviser: Yeah, but again, this is getting expensive for you.
Owner: This all seems so complicated . . .
Adviser: It isn’t, really, . . .
Owner: I’m just going to make them an owner. Keep it simple.
Adviser: You’re a pig-headed @#^*. Why do you waste my time, and your money? Go ahead, do whatever you want. Just do me one favor.
Owner: What is it?
Adviser: Two favors. Now hear me out. If you follow through with this nonsense, give this uber-employee of yours non-voting stock – remember, we recapitalized the company to provide for a class of non-voting stock when we talked about making some gifts to a trust for your kids? – and have them sign a shareholders’ agreement.
Owner: Why a shareholders’ agreement?
Adviser: For starters, because you want to restrict their ability to sell their shares, you want to have the right to buy back their shares if they leave the business for any reason, and you want to have the right to compel them to sell their shares if you decide to sell yours.[x]
You can also reduce the amount of compensation income to the employee by incorporating certain “non-lapse restrictions” to reduce the valuation of the shares . . .[xi]
Owner: Sounds reasonable. I’ll consider it. Say, are you free for golf next Monday?
Adviser: I would have thought that, by now, you’d know that I don’t golf. By the way, did you know that golf courses are identified as a “sin business” under the qualified opportunity zone rules?[xii]
Fast Forward a Few of Years
The key employee (the “Employee”) is a minority shareholder in the business (the “Business”).
There is no shareholders’ agreement between the Owner and the Employee. The Owner has gifted some shares in the Business to an irrevocable grantor trust for the benefit of the Owner’s issue.[xiii]
The Owner and the Employee have had some differences of opinion over dividend policy and the direction of the Business, generally. The Owner has been reinvesting the profits in order to prepare the Business for a sale; the Employee would like to withdraw these profits to help pay for family expenses, including tuitions.
The Adviser is being treated for an ulcer, anxiety, and depression.[xiv]
The Owner – who has been semi-retired for the last few years, and whose golf game has improved substantially – has been approached by a competitor (the “Buyer”) with an offer to buy the Business; specifically, the Buyer has offered to purchase all of the issued and outstanding shares of the Business in exchange for cash at closing, and with five-percent of the sale price to be held in escrow for eighteen months.[xv]
The Buyer plans to consolidate the Business into the Buyer’s existing infrastructure.
In recognition of the Employee’s status in the Business, the Employee has been offered an employment agreement to stay on with the Buyer for a couple of years, on the theory that their assistance will be required in order to effectuate the smooth transition of the Business’s customers. The agreement may be extended at the Buyer’s option.
The Owner is eager to consummate the deal on the terms offered. The price is right and the terms are fair[xvi] – at least in the eyes of the Owner.
The Employee is less bullish about the transaction. In fact, the Employee has given some indication that they will likely refuse to sell their shares.
The Employee thinks the Business is worth more than the Buyer has offered, and they believe they deserve more than just a short-term employment agreement.
What’s more, the Employee would like to defer some of their gain by rolling over some of their equity in the Business.[xvii]
The Employee also believes that only the Owner should be liable for any losses suffered by the Buyer on a breach of any representations and warranties regarding the Business – after all, the Owner controlled the Business.[xviii]
With the Owner’s dream of a stock sale in jeopardy, the Owner approaches the Adviser.
After several attempted “I told you so’s,” – especially regarding the drag-along in the non-existent shareholders’ agreement – which the Owner has somehow parried, the Adviser suggests that the Owner approach the Buyer about employing a reverse merger to force the Employee to sell their shares.[xix]
The Adviser explains that the Buyer would create a subsidiary, which would then merge with and into the Business, with the Business as the surviving entity.[xx] As a result of the merger, the Employee would receive the cash consideration provided for by the merger agreement; because the cash for this consideration would come from the Buyer, the transaction would be treated, for tax purposes, as a purchase of the Business’s shares by the Buyer. If the Employee was dissatisfied with this consideration, they may exercise their dissenter’s or appraisal rights under state law, but they would cease to be a shareholder of the Business.
However, the Owner doesn’t want to approach the Buyer. He doesn’t want to alert the Buyer to the dissension, for fear that it may spook the Buyer and jeopardize the deal.
The Adviser suggests that the Owner may effect the same kind of squeeze-out without involving the Buyer. He explains that the Owner may form a new corporation which would be merged into the Business with the Business surviving. The Employee would either accept the consideration provided under the merger agreement, or they would exercise their appraisal rights.
Again, the Owner rejects the Adviser’s suggestion, fearing that any squeeze-out would antagonize the Employee – and unnerve the Buyer, which planned to retain the Employee’s services for a period of transition – and that any litigation brought by the Employee in exercise of their dissenter’s rights would kill any deal with the Buyer.
“What if I purchased the Employee’s shares myself?” the Owner asks the Adviser. “I’d buy them for a premium over the per share price offered by the Buyer. I’d give the Employee my own promissory note, and I would satisfy it immediately after I sold the Business to the Buyer. That way, I keep the Buyer out of the picture, and I save my deal.”
After some research, and under the facts and circumstances described, the Adviser makes the following observations and conclusions:
- the IRS may collapse the two sale transactions – from the Employee to the Owner, and from the Owner to the Buyer – and treat them as one;
- in that case, the IRS would consider the Owner and the Employee as each having received their pro rata share of the consideration from the Buyer;
- any “excess” received by the Employee over their pro rata share may be considered as a payment from the Owner in a separate transaction.[xxi]
- because of the Employee’s status in the Business as a key employee, this payment may be treated as ordinary compensation income;
- in that case, the payment should also be deductible;
- alternatively, the IRS may treat the “excess” payment as having been made by the Owner to secure the Employee’s agreement to sell their shares;
- according to the IRS, this would represent ordinary income to the Employee, but a capital expenditure by the Owner.
The Owner is incredulous. “Wait,” he says, “if I purchase the Employee’s shares at a premium in order to remove the Employee as an obstacle to a sale of the Business to the Buyer, the Employee will have ordinary income? The Employee will never agree to that. How is that possible where the Employee is selling shares of stock? Can’t we just say that the Employee negotiated a better deal, or was in a better bargaining position than I was?”
Historically, the IRS has viewed with skepticism the receipt by shareholders of distributions from their corporation or of payments from a third party – in each case, purportedly in the shareholders’ capacity as such – when the amount received is disproportionate to their share holdings.
Thus, when property is transferred to a corporation by two or more persons in exchange for stock, and the stock received is disproportionate to the transferor’s prior interest in the property, the transaction may be treated as if the stock had first been received in proportion and then some of such stock had been used to make gifts, to pay compensation, or to satisfy some other obligation of the transferor, depending upon the facts and circumstances.[xxii]
The same analysis may be applied to the liquidation of a corporation where the majority shareholder (“M”) accepts less than the pro rata share of the liquidating distribution to which M is entitled – but which would nevertheless generate a gain on M’s investment – in order that an unrelated minority shareholder may receive more than their pro rata share, thereby avoiding a loss on their investment.
The non pro rata liquidating distribution by the corporation to the shareholders would be treated for tax purposes as if there had been a pro rata distribution to each shareholder in full payment in exchange for each shareholder’s stock, together with a transfer by M to the minority shareholders of an amount equal to the excess of the amount received by the minority over the minority’s pro rata share of the liquidating distribution. The difference between M’s pro rata share and the amount actually received by M would be treated as having been paid over by M to the minority shareholders in a separate transaction, the tax consequences of which would depend upon the underlying nature of the payments, which in turn depends upon all of the relevant facts and circumstances, “which must be determined from all of the extrinsic and intrinsic evidence surrounding the transaction.”[xxiii]
The foregoing would seem to support a preemptive move by the majority owner of a business, one undertaken well in advance of a sale of the business – and perhaps in “collaboration” with the minority – including by way of a squeeze-out. Such a buy-out of the minority’s interest may include a purchase price adjustment in the event the business is sold within a relatively short period after the buy-out.[xxiv]
The Tax Court
The Tax Court, on the other hand, seems to have been more receptive to the taxpayer’s position. In one case,[xxv] the issue was whether a payment made by Target’s majority shareholder (“Majority”) to a minority shareholder (“Minority”) in settlement of a lawsuit for damages for failure to deliver certain property constituted capital gain or ordinary income.
Minority filed suit against Majority for damages resulting from their failure to deliver certain options to Minority. The options were the subject of an oral agreement arising out of a plan of merger for Target. Minority objected to the portion of the plan of merger which provided for the redemption of some Majority shares by the transfer to Majority of some interest in real estate. Minority contended that the real estate was worth much more than the value assigned to it for purposes of the redemption, and they demanded to share in the redemption. Minority threatened court action to block the merger unless their demands were met.
Minority contended that the options, if executed, represented consideration for their stock in Target. The IRS contended that the options were in the nature of compensation for Minority refraining from blocking the merger; it sought to tax the settlement as ordinary income because Minority agreed not to vote against the merger.[xxvi]
The Court concluded that the options were promised as additional consideration for the Target stock owned by Minority. Majority and Minority, the Court stated, were “frantically attempting to settle their differences before the shareholders meeting which was called to vote on the merger.” According to the Court, Minority demanded more from the merger, and Majority offered the options.
The Court found as a fact that the quid pro quo for the agreement to deliver the options was additional consideration for the Target stock owned by Minority. The taxability of the settlement, the Court continued, was controlled by the nature of the litigation, which was controlled by the origin and character of the claim which gave rise to the litigation. Having found that the claim arose out of the purported inadequacy of the consideration received in the merger, it followed that the settlement represented additional consideration for Minority’s disposition of its shares in Target.
What’s an Owner to Do?
If the Employee-minority shareholder had been party to a properly drafted shareholders’ agreement, the situation described above may have been avoided. Of course, if the Employee had never been made a shareholder of the Business to begin with . . . .[xxvii] Perhaps a change-in-control bonus payment would have sufficed.
In any event, advisers are often presented with facts and circumstances beyond their control. A shareholder’s dual capacity – as an employee and as an investor – may complicate the tax treatment of a non-pro rata payment, as indicated above; it may invite closer scrutiny of the arrangement by the IRS.
In light of the Tax Court’s holding and the IRS’s contrary position, and provided the payment by the majority shareholder is, in fact, being made to a minority shareholder in their capacity as an investor – rather than as a compensatory incentive – it will behoove the parties to document the arrangement as thoroughly and as contemporaneously as possible in order to substantiate their position and support capital gain treatment for the payment.
[i] I have taken poetic license here and there to pull together (even manufacture) a smorgasbord of “facts” and issues and to provide some color, in order to convey today’s message.
[ii] In other words, there is no deferral within the meaning of IRC Sec. 409A.
[iii] IRC Sec. 83.
[iv] The Federal exemption is currently set at $11.4 million per individual donor. IRC Sec. 2010.
[v] IRC Sec. 83.
[vi] The federal gift tax return, Form 709, requires that the donor describe their relationship to the donee.
If the employer-company is a pass-through entity, such as a partnership or S corporation, the employee-owner will receive a K-1 (assuming they are vested in the equity or they have made a Sec. 83(b) election).
In other words, there a many ways for the IRS to figure out what happened.
[vii] The “vesting” event is usually tied to the employee’s having served the business for a prescribed number of years, though it may also be tied to the employee’s attainment of certain performance goals. See, e.g., Reg. Sec. 1.83-3.
[viii] Subject, of course, to the principles of the constructive receipt and economic benefit doctrines, and the deferral/distribution rules under IRC Sec. 409A.
[ix] A couple of assumptions here: (1) the compensation is reasonable for the service rendered; the fact that the sale occurs may satisfy the standard; and (2) the compensation will not trigger Sec. 280G’s “golden parachute” rules; these rules do not apply to a certain small business corporations (like an S corporation), or to certain corporations that timely secure shareholder approvals to the payment arrangement.
[x] The last item is known as a “drag-along.”
[xi] Reg. Sec. 1.83-5. A bona fide arrangement will not create a second class of stock where the employer is an S corporation. Reg. Sec. 1.1361-1(l).
[xii] IRC Sec. 1400Z-2(d)(3)(A)(ii) and Sec. 144(c)(6)(B).
[xiii] The appraisal reflects valuation discounts for lack of marketability and lack of control. The gifts occur well before the offer to buy described below.
[xiv] The Adviser still associates the word “golf” with a VW hatchback.
[xv] The shareholders are thereby assured of only one level of gain recognition, all of which will be capital gain, in contrast to an asset sale, which would be taxable to the corporation and then to the shareholders, and which could generate ordinary income.
[xvi] For example, with customary representations and warranties, covenants, and indemnity provisions.
[xvii] The Owner has no interest in leaving any of his equity at risk in the Business after his departure.
[xviii] These serve several functions; for example, they help flesh out the state of the target business as of the date of the purchase and sale agreement and, if different, as of the closing date – a disclosure or due diligence function; if the seller cannot make the statements at the time of closing (as where the agreement is signed on one day and the closing occurs on a later day), the reps and warranties allow the buyer to walk away from the deal; and if the buyer suffers a loss after the closing that is attributable to a breach of these statements, the buyer may seek indemnity from the seller for such breach.
[xix] A form of squeeze-out technique.
[xx] A reverse subsidiary merger.
[xxi] See, e.g., Rev. Rul. 73-233. Y corporation wished to acquire X by statutory merger in exchange for 100 shares of stock of Y corporation. The stock of X was owned by three individuals: A owned 60 percent of the stock of X, and B and C each owned 20 percent of the stock of X. A two-thirds vote of the target corporation’s shareholders in favor of the merger was required to meet the applicable merger laws of the State in which X was incorporated. B and C refused to vote in favor of the proposed merger unless they would each receive 25% of the consideration. In consideration for B and C voting in favor of the merger, A agreed to permit B and C each to receive 25 shares of Y stock instead of the 20 shares of Y stock which they would have been entitled to receive had the distribution of the merger consideration to the X shareholders been in proportion to their stock ownership of X. In order to effectuate this agreement, A contributed one-third of his stock in X to the capital of X with the result that A’s stock interest in X was reduced to 50 percent and B’s and C’s stock interests were each increased to 25 percent. The X shareholders then voted unanimously in favor of the merger which was thereafter consummated. A, B, and C received, respectively, 50, 25 and 25 shares of Y stock in exchange for their X stock.
According to the IRS, under the circumstances described, the contribution of X stock by A to the capital of X prior to the merger will not be considered independently of the related events surrounding the contribution. The other related events to be considered are (i) the agreement of B and C with A to vote in favor of the merger if B and C would each receive five additional shares of Y stock, and (ii) the merger.
Accordingly, the overall transaction will be viewed as (1) a merger of X into Y with a distribution of 60, 20 and 20 shares of Y stock to A, B, and C, respectively, in exchange for their X stock, with no gain or loss being recognized to A, B, or C on this exchange under IRC Sec. 354, and (2) a transfer by A of five shares of Y stock to B and five shares of Y stock to C in consideration for their voting in favor of the merger.
Gain or loss will be recognized to A on his transfer of 10 shares of Y stock, five to B and five to C, to the extent of the difference between the fair market value of the stock and the adjusted basis of the stock in A’s hands at the time of the transfer.
Since the transfer by A of Y stock to B and C was in satisfaction of B and C voting for the merger which enabled A to acquire the Y stock, such transfer will be considered a capital expenditure and, therefore, not a deductible expenses to A. A will be permitted to adjust the basis of his remaining 50 shares of Y stock by increasing his basis in such stock by the fair market value of the 10 shares given up.
The fair market value of the five shares of Y stock received by B and C, respectively, from A is includible in their gross incomes.
[xxii] Reg. Sec. 1.351-1(b).
[xxiii] Rev. Rul. 79-10.
[xxiv] Like an installment sale with a fixed maturity date but a contingent purchase price. Reg. Sec. 15A.453-1(c).
[xxv] Gidwitz Family Trust v. Comm’r, 61 T.C. 664 (1974).
[xxvi] A “negative” service, like a payment for a non-compete?
[xxvii] I told you so.