This is the first in a series of brief articles exploring different exit strategies - ways of monetizing ownership in a company - that are available to affiliate shareholders of private corporations. Other exit strategies I intend to examine include liquidation, acquisition/merger, and going public. An affiliate of a company is a person that directly or indirectly, through one or more intermediaries, controls or is controlled by or is under common control with, such company.[i] Common affiliates include directors, executive officers, and greater than 10% shareholders of a corporation. While the presence of any one of these relationships may be sufficient to confer affiliate status on the person bearing such relationship to the corporation, we frequently see companies with individuals who wear all three hats. Affiliate shareholders must tread carefully when devising and executing an exit strategy because different rules typically apply to affiliate shareholders. One such exit strategy is called “milking” the business.
Milking the Business
“Milking” the business, for lack of a better term, refers to the daily extraction of cash from a corporation in the form of salaries, bonuses, dividends, interest, rent, etc. Affiliates who pursue this exit strategy simply forego reinvesting earnings to grow the business in favor of rewarding themselves with generous salaries, big bonuses, debt instruments with ample interest payments, preferred stock that pays fixed dividends, and high rent payments for property leased to the corporation. Milking the business may make sense under a variety of circumstances, but affiliate shareholders who implement this strategy must leave the corporation with sufficient working capital to cover the day-to-day expenses of running the business. Additionally, two important considerations in determining if this exit strategy could work for your business are (1) the tax implications and (2) the presence of minority shareholders to whom affiliates owe certain fiduciary duties.
Tax Implications
Milking the business, if implemented correctly, can be advantageous from a tax perspective. For instance, various payments to shareholders such as reasonable salaries, reasonable rent for property leased to the corporation, and interest on bona fide loans by shareholders to the corporation are deductible by the corporation.
The payment of dividends, on the other hand, results in double-taxation and reveals a major drawback to the corporate form. In a C corporation, corporate profits distributed in the form of dividends to the shareholders are effectively taxed twice: First, the corporation will have paid taxes on those profits as earned; and then, the shareholders have to pay taxes individually for the dividends received (the current individual tax rate on dividends is capped at 15% but, under the Obama administration, this tax rate is likely headed higher). Corporate profits distributed as dividends are thus subjected to double- taxation.
There is an important caveat for affiliates who pursue the milking the business exit strategy. Payments to shareholders as salaries, rents, reimbursements, etc. are deductible only to the extent they constitute “reasonable” business expenses. Any amount paid in excess of a “reasonable” amount may be treated as a constructive dividend to the shareholder which is not deductible by the corporation and is subject to double taxation.
Common methods for establishing the reasonableness of rent include the use of professional appraisers and other evidence showing comparable rents paid by unrelated parties.[ii] Whether compensation paid to an affiliate shareholder is reasonable is a factual question which must be determined in light of all of the evidence.[iii] The courts have considered many factors, including (1) the employee’s qualifications, (2) the nature, extent and scope of the employee’s work, (3) the size and complexities of the business (4) the prevailing general economic conditions, (5) a comparison of salaries paid with the gross income and the net income of the business (6) comparison of salaries with distributions to stockholders (7) the prevailing rates of compensation for comparable positions in comparable concerns (8) the salary policy of the corporation as to all employees, and (9) in the case of small corporations with a limited number of officers, the amount of compensation paid to the particular employee in previous years.[iv]
Thus, tax planning for a private corporation should focus on finding legitimate grounds for making reasonable payments to the affiliate shareholders as salaries, rents, etc. that will be deductible by the corporation – as opposed to distributing dividends which are not deductible. In addition, when approving these reasonable payments, affiliates who wear multiple hats must be particularly careful not to breach their fiduciary duty of loyalty.
Fiduciary Duty of Loyalty
A duty of loyalty is owed by each director to the corporation and its shareholders. Under Delaware law, which boasts a more well-developed body of corporate case law than other states, the duty of loyalty mandates that a director not consider or represent personal or other interests except the best interests of the corporation and its stockholders in making a business decision.[v] Improper directorial conduct involves board approval of contracts and transactions to enhance personal financial gain of one or more directors.
Section 144 of the Delaware General Corporation Law is a safe harbor statute governing certain interested director transactions. Section 144 provides that a contract or transaction with an interested director is not void or voidable solely because of the conflict of interest, provided: (a) there has been good faith approval by a majority of disinterested directors; or (b) there has been approval in good faith by an informed majority of shareholders; or (c) the transaction is fair to the corporation. If options (a) and (b) are not available, interested directors of a corporation must be prepared to demonstrate that the proposed transaction is fair to the corporation and its stockholders.
Delaware law requires entire fairness in interested director transactions, and entire fairness requires a showing of fair dealing as well as fair price.[vi] The standard of “entire fairness” is the highest legal standard imposed under Delaware corporate law.
Fair Dealing. Fair dealing embraces questions of procedural fairness. Relevant issues include when the transaction was timed, how it was initiated, structured, negotiated, disclosed to the directors, and how the approvals of the directors and the stockholders were obtained.[vii]
Fair Price. Fair price relates to the economic and financial considerations of the proposed transaction, including all relevant factors: assets, market value, earnings, future prospects, and any other elements that affect the intrinsic or inherent value of a corporation’s stock.[viii]
The rationale for imposing the “entire fairness” burden is that in a self-dealing transaction, the minority shareholders’ interests are not being adequately safeguarded because the fiduciaries charged with protecting the minority have a conflicting self interest.[ix] When directors do not act “fairly” in structuring a transaction, they breach their duty of loyalty, and the result may be either an injunction[x] or damages.[xi] Conversely, as long as the contract or transaction is the product of fair dealing and fair price, the transaction should be upheld.
Even though the “entire fairness” test requires examination of both fair dealing and fair price, in a non-fraudulent transaction, price may be the preponderant consideration outweighing other features of the transaction.[xii]
Disclosure Obligations
Consistent with the obligation of “fair dealing,” directors of corporations have a fiduciary duty to disclose fully and fairly all material information within the board’s control when it seeks stockholder action.[xiii] Delaware law not only requires disclosure of the director’s interest or conflict, but also requires disclosure of the material facts relating to the proposed transaction and any underlying or related material information, assumptions, projections, etc. In transactions involving shareholder action, the disclosure obligations are broad and uncompromising.
Information is deemed to be “material” if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote. Put another way, there must be a substantial likelihood that the disclosure of any omitted fact would have been viewed by a reasonable shareholder as having significantly altered the “total mix” of information made available.[xiv] In addition to the duty to disclose all facts material to the proffered contract or transaction, directors are under a fiduciary obligation to avoid misleading or partial disclosures.
Conclusion
As discussed above, affiliate shareholders can monetize their ownership in a corporation by extracting cash from the corporation on a regular basis in the form of salaries, bonuses, dividends, interest, and rent. However, while pursuing this exit strategy, affiliate shareholders should focus on approving payments to themselves that are reasonable, and, therefore, deductible by the corporation. Additionally, when affiliate shareholders wearing multiple hats approve these payments, they must not breach their fiduciary duty of loyalty which imposes specific requirements involving interested director standards and disclosure obligations. The standard of entire fairness in interested director contracts and transactions requires a showing of fair dealing as well as fair price. Moreover, interested directors must satisfy their disclosure obligations by fully and fairly disclosing to shareholders all material facts relating to the directors’ interest or conflict as well as the transaction and related information.
This article is intended only as a general discussion of the foregoing issues and should not be regarded as legal advice.
Edward H. Weaver is an attorney with The Lebrecht Group, APLC, located in Irvine, California and Salt Lake City, Utah. He can be reached at (801) 983-4948 oreweaver@thelebrechtgroup.com . Please visit our website at www.thelebrechtgroup.com for further information.
[i] Sec. 77p(f)(1) of the Securities Act of 1933.
[ii] Sparks Nugget, Inc. et al. v. Commissioner, supra; J.J. Kirk, Inc. v. Commissioner, 34 T.C. 130 (1960), aff ’d 289 F.2d 935 (6th Cir. 1961); Ross Auto Parts, Inc. v. Commissioner, T.C. Memo. 1957-120; Audano et al. v. United States, supra; Robinson Truck Lines, Inc. v. Commissioner, 183 F.2d 739 (5th Cir. 1950); Tillotson v. McCrory, 202 F.Supp. 925 (Dist. Neb. 1962).
[iii] Pacific Grains, Inc. v. Commissioner, 399 F.2d 603 (9th Cir. 1968), aff ’g. T.C. Memo. 1967-7; Hoffman Radio Corp. v. Commissioner, 177 F.2d 264 (9th Cir. 1949); Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315 (2d Cir. 1987).
[iv] Mayson Manufacturing Co., 178 F.2d 115 (6th Cir. 1949).
[v] Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173, 182 (Del. 1986).
[vi] Weinburger v. UOP, Inc., 457 A.2d 701 (Del. 1983).
[vii] Id. at 711.
[viii] Id.
[ix] Id. at 710.
[x] Mills Acquisition Co. v. Macmillan, Inc., 559 A.2d 1261 (Del. 1989).
[xi] Weinburger, 457 A.2d 701 (Del. 1983).
[xii] Id. at 711.
[xiii] Zirn v. VLI Corp., 681 A.2d 1050, 1052 (Del. 1996).
[xiv] Id.
