The Closely Held Business & the Minority Owner: Accessing Information from the Entity’s Tax Return?
March 19, 2018
Why a Minority Owner?
I have often asked the question, “Why would someone willingly become a minority owner in a closely held business?” Similarly, I have often advised clients who control their own business not to admit a minority owner into the business.
In the face of my ill-concealed bias against one’s becoming a minority owner, or one’s admitting another as such, I recognize that there are many reasons why, and circumstances in which, the admission of a minority owner may be necessary, even valuable, to the business, at least initially.
The controlling owner may have to offer equity to a key or prospective employee in order to retain their services, or to a potential investor in order to acquire a badly needed infusion of capital. In each of these situations, the business owner and the employee, or investor, should first decide upon the terms of their relationship; for example, voting rights, supermajority voting requirements, responsibility for day-to-day management, vesting schedules (if any), distributions, preferred returns, put or call rights, drag-along or tag-along rights, buy-sell arrangements (on death, disability, termination of employment, etc.), transfer restrictions, access to financial information, and many other factors should be considered.
The Oppression of the Minority
I have never wished ill upon a closely held business or its owners – I have seen the work ethic, the dedication, and the courage that mark the successful entrepreneur – but we have all seen how business relationships can sour, how the controlling owner can make life miserable for a minority owner (and sometimes vice versa), and how this state of affairs may adversely affect the business.
The controlling owner has the means – especially in the absence of a shareholders’ or partnership agreement – by which they can inflict all sorts of “hurt” on the minority owner; for example, they may:
- exclude the minority owner from a role in the management of the business,
- cause the business to enter into agreements that must be personally guaranteed by the owners of the business, including the minority,
- use company assets for non-business, even personal, purposes,
- withdraw an excessive amount of compensation,
- deny employment to the minority owner,
- employ or otherwise benefit family members,
- accumulate an unreasonable amount of earnings in the business, without the distribution thereof,
- fail to make distributions for taxes,
- cause the business to pay an excessive amount of rent for the use of property owned by the controlling owner,
- divert business opportunities to related entities in which the minority owner has no equity interest,
- fail to make the books and records of the business available to the minority owner.
Information from the Business Entity?
A minority owner may not have actual knowledge of many of the foregoing activities, though they may suspect that something is amiss. But how would they confirm this suspicion without acquiring information regarding the business?
They can ask the controlling owner to show them the books and financial records of the business, but how forthcoming will the controlling owner be? Is the minority owner ready to bring, and bear the cost of, a law suit to enforce their rights to such access under applicable state law, or under the terms of a shareholders’ or partnership agreement? From a strategic perspective, does the minority owner even want to alert the controlling owner that they are looking for such information?
Are there other sources of information, that are “freely” given by the business, by which the minority owner may determine whether the controlling owner is, in fact, engaging in “questionable” behavior?
In the case of a minority owner in a pass-through entity, such as a partnership, limited liability company, or S corporation, the owner will receive a Sch. K-1 that reflects the owner’s share of the business’s items of profit or loss, plus any distributions made to the minority owner; if the business entity is a C corporation, and dividends were paid to shareholders, the minority owner will receive a Form 1099-DIV reflecting the amount distributed to the owner; if the minority owner is “employed” by the business, the amount paid to them will be shown as a guaranteed payment in the case of a Sch. K-1 issued by a partnership or LLC, or on a Form W-2 in the case of a corporation.
Unfortunately, these tax reports contain information that is limited to the minority owner – they do not provide any direct information relating to the activities of the controlling shareholder.
There is Another Way . . .
The business entity’s tax return, however, contains a wealth of information regarding both the business and the controlling owner. The tax return for an S corporation (and the forms, statements and schedules attached thereto), for example, will include information regarding the compensation of shareholder-officers/employees, rents paid (which the minority owner may know are paid to an entity owned by the controlling owner), the identity of any subsidiaries (and possibly information regarding loans among the related entities), loans to shareholders, loans from shareholders, and other data.
That’s all well and good, but how may a minority owner obtain a copy of the business entity’s tax return, and may the return be obtained without putting the entity and the controlling owner on notice?
IRC Sec. 6103
The Code provides that “the return of a person shall, upon written request, be open to inspection by or disclosure to, in the case of:”
- a partnership, any person who was a member of such partnership during any part of the period covered by the return;
- a corporation, any bona fide shareholder of record owning 1% or more of the outstanding stock of such corporation; and
- an S corporation, any person who was a shareholder during any part of the period covered by such return during which an S election was in effect.
Thus, based upon the flush language of the Code, a partner or S corporation shareholder can obtain a copy of the Form 1065 or Form 1120S filed by the partnership or S corporation. Indeed, even a minority shareholder of a C corporation has the right to obtain a copy of its corporation’s Form 1120.
The term “return” includes any tax or information return, any claim for refund, and any amendment or supplement thereto, including supporting schedules or attachments which are supplemental to, or part of, the return.
By contrast, “return information” may also be open to inspection by, or disclosure to, any person authorized above, provided the IRS determines that such disclosure would not seriously impair federal tax administration. The term “return information” includes, among other things, whether the return, was, is being, or will be examined, data prepared by or collected by the IRS with respect to the return or the determination of any liability, any closing agreement, and other items.
When it passed the Tax Reform Act of 1976, Congress clearly distinguished between “returns” and “return information,” allowing greater access to tax returns than to return information:
Under the Act, disclosure can be made, upon written request, to the filing taxpayer, . . . , the partners of a partnership, the shareholders of subchapter S corporations, . . . , [and] a one-percent shareholder . . . . Return information (in contrast to “returns”) may be disclosed to persons with a material interest only to the extent the IRS determines this would not adversely affect the administration of the tax laws.
Based on the foregoing, one would reasonably conclude that the Code provides a minority shareholder or partner an alternative means by which to obtain information regarding the economics of a business entity where the controlling owner may not be forthcoming in sharing it.
. . . Or is there?
Actual experience, however, undermines that conclusion.
First of all, Form 4506, Request for Copy of Tax Return, inexplicably requires that the filing partner or shareholder certify that they have the authority to execute the form “on behalf of” the partnership or corporation the return of which is being requested by such partner or shareholder. How would a minority owner, from whom information is probably being withheld by the taxpayer-business entity, ever hope to secure authorization from such entity – i.e., from the controlling owner – to obtain a copy of the entity’s tax return?
Our own recent experience with the IRS (and even with the Taxpayer Advocate) has been anything but reassuring. “You will need to get the permission of the taxpayer,” we have been told. “No we don’t,” we have replied, “please take a look at Code Sec. 6103(e). . . . Sure, we’ll fax it to you.” Then, “Did you see what we sent over? OK. Why would we still need the corporation’s permission? Our client was a shareholder during the years for which we are requesting the copy, and still is. We sent you the K-1.” And, in reply, “but your client is not the taxpayer that filed the return.”
What Are We Missing?
Thinking that perhaps we had missed something, we reviewed the legislative history, part of which was recited above. That confirmed our understanding.
We turned next to the Internal Revenue Manual for some insight. The relevant provision begins by stating that:
Persons described in IRC Sec. 6103(e) always have access to the appropriate return as specified in IRC Sec. 6103(e)(1) through IRC Sec. 6103(e)(10) for partnership, . . . or Subchapter S returns which are discussed in this IRM . . .
The Manual then turns to a discussion of the persons to whom returns and return information may be disclosed, and the circumstances under which the disclosures can take place, beginning with partners.
Returns and return information of a partnership may be disclosed to any person who was a member of the partnership during any part of the period covered by the return. . . . IRC Sec. 6103(e)(10) provides that information to be disclosed cannot include any supporting schedule, attachment, or list that contains third party taxpayer identifying information other than that of the individual making the request for access. A requesting partner cannot receive any Form K-1 or other attachments that include identifying information of other partners or other individuals. The partner can receive only the Form K-1 that pertains to his or her interest in the partnership. See Exhibit 11.3.2-2, which contains detailed guidance about information that can be released to partners seeking access to partnership returns, including schedules that must be restricted or sanitized prior to release . . . .
Before disclosing a partnership’s tax returns, the Manual states that the IRS must verify that the person who has asked for the information was a partner during the requested tax year.
To determine whether a requester was a member of the partnership for the year requested, verify that a schedule K-1 was filed for the requester. . . . It is up to the requester to provide sufficient identifying information for the IRS to verify that he or she is a partner . . . .
The discussion then switches to S corporations. The Manual provides that a Form 1120S may be disclosed to any person who was a shareholder during any part of the period covered by the return requested during which an S corporation election was in effect. Shareholders may receive Subchapter S returns, regardless of the percentage of shares held. However, the Manual notes that:
Not all Schedules K-1 attached to the Sub-Chapter S return (Form 1120S) can be provided in response to a written request for access. Only the Schedule K-1 for the person making the request can be released. Any other schedules or attachments containing other 3rd party information must be sanitized or withheld per IRC §6103(e)(10). See Exhibit 11.3.2-3 for more details about what can be released and what needs to be edited or sanitized prior to release.
As for regular C corporations, the Manual explains that a corporation’s tax return may be disclosed to any bona fide shareholder of record owning 1% or more of the outstanding stock of the corporation. The requester must submit documentation which reasonably demonstrates such ownership. Corporate stock certificates displaying the corporate seal, and a printout from a state regulatory body, such as the Secretary of State’s Office, detailing the total outstanding shares of stock currently in existence, may be used to verify the percentage of ownership. The Manual states that:
If any doubt exists whether the requester meets the 1% threshold, it is permissible to contact the corporation whose information is at issue to determine if they agree that the requester owns at least 1% of its outstanding stock. The requester should be advised and given an opportunity to withdraw their request if the corporation will be contacted.
All facts and circumstances must be obtained and evaluated, the Manual explains, when determining if a shareholder is a bona fide owner of stock. While the Code does not define the term “bona fide,” the Manual states that a shareholder is not considered bona fide if the shares were acquired for the purpose of obtaining the right to inspect the returns of the corporation.
The requirement that a shareholder be bona fide has a direct correlation to the states’ statutory requirements that a shareholder seeking to inspect the books and records of the corporation have a proper purpose to do so. Generally, the “proper purpose” requirement means the purpose for inspection must reasonably relate to the requester’s interests as a shareholder, but must not be adverse to the interests of the corporation whose information will be accessed. Proper purpose does include . . . a situation where the shareholder is a competitor seeking to take over the corporation. The fact that the shareholder is a competitor, even in a hostile takeover situation, does not defeat the shareholder’s statutory right of inspection.
If At First You Don’t Succeed, Persevere
Based on the foregoing, a minority owner of a partnership or of an S corporation, and a 1% shareholder of a C corporation, should be able to obtain from the IRS a copy of the partnership or corporate tax return, notwithstanding the controlling owner’s refusal to share such tax return or to authorize the minority owner to contact the IRS, and notwithstanding what appears to be a lack of knowledge on the part of many IRS employees.
Perhaps some majority owners, if made aware of the minority’s ability to legally obtain such information from the IRS – in spite of their efforts to deny such access – will, instead, provide the information voluntarily, perhaps in the hope of heading off, de-escalating, or resolving any dispute, and certainly in the hope of keeping the IRS out of any dispute.
Alternatively, might the controlling owner act more fairly vis-à-vis the minority owner, at least insofar as their treating with the business entity is concerned, if they realize that the minority owner has it within their power to obtain copies of business tax returns from the IRS, and the terms of those transactions are reflected on such returns? One can only hope.
 Beyond inheritance, for example. Speaking of inheritance, it probably results in the death of many a closely held business, at least where there has not been any succession planning, and where there is no well-drafted shareholders’ or partnership agreement. Mom and dad know best? Not always.
 Minority owners should insist upon certain safeguards, including, for example:
- the assurance of receiving some minimum level of regular distributions from the business (at least to cover estimated or annual income taxes in the case of a pass-through entity),
- being able to put some or all of their equity to the business (at least upon one’s demise), and
- having a right to vote on certain major business decisions.
 A bit of good luck doesn’t hurt either.
 This is where a well-drafted shareholders’ or partnership agreement may be vital. Of course, it may also be the reason, in hindsight, that such an agreement was never entered into.
 Did you think that only politicians do that sort of thing?
 This is a commonly used tool of “oppression” in pass through entities. The minority owner will be subject to income tax, and perhaps employment taxes, whether or not the entity’s profits are distributed to the owners. By withholding distributions from them, the minority owners (especially those that are not even employed by the business) may be forced to use other assets (which they may have to liquidate) to pay their tax liabilities.
 To Form 1065 or Form 1120S, as the case may be.
 Technically speaking, a partner cannot be an employee of their partnership, though they may be rendering services comparable to one, and for which they are compensated without reference to the profits of the partnership.
 Assuming the return is prepared properly and accurately. That’s a whole other story.
 IRC Sec. 6103(e)(1)(C) and (D). The return shall also be open to inspection by or disclosure to the attorney in fact authorized in writing by any of the persons described above to inspect the return or receive the information on his behalf.
 Including an LLC that is treated as a partnership for tax purposes. Of course, an LLC may elect to be taxed as a corporation.
 It should be noted that the information disclosed or inspected must not include any schedule, attachment or list that includes the TIN of a person other than the entity making the return or the person conducting the inspection or to whom the disclosure is made. Thus, for example, a requesting partner cannot receive any Form K-1 or other attachments that include identifying information of other partners.
 General Explanation of the Tax Reform Act of 1976, Joint Committee on Taxation, pg. 335.
 Why else would one resort to filing Form 4506?
 IRM 11.3.2.
 It is difficult to reconcile this language with our recent experience with requesting copies of tax returns. The Code, Congress, and the Manual contemplate ready access.
 They were not acquired for a business purpose.
 As the rabbi’s son says in the first scene of Fiddler on the Roof: “May God bless and keep the czar — far away from us.”
 Of course, there is always the possibility of a fraudulent return but, in that case, the controlling owner has much more to worry about than a disgruntled minority owner.