You’re an attorney.  It’s the year after you and your client happily settled via buy-out a dissolution case you brought on behalf of a minority shareholder in a close corporation.  Your former client leaves you a voice mail asking for a return call.  Her voice sounds upset.  When you call back, she tells you she just received a Schedule K-1 tax form from her old company for last year and, her voice rising with anxiety, that it allocates to her a substantial net income sum that she never received.  Surely, she says, it’s a mistake that must be corrected if she’s to avoid owing taxes on money she never got.  Isn’t it outrageous, she insists, that her former business partners are shifting taxes to her on earnings that stayed with the company for their benefit.

Outrageous or not, whether the client gets saddled with personal taxes on such “phantom” income likely will depend on the terms of the buy-out agreement.  If the selling shareholder and her counsel did not foresee the possibility of a positive net income allocation for that portion of the tax year preceding the buy-out’s effective date, and did not negotiate a tax payment in the buy-out agreement to the extent of any non-distributed allocation of net income, the former client likely will be writing a bigger check to Uncle Sam, and the attorney likely will not be getting repeat business from the client.  The likelihood of being stuck with a tax bill is even higher if, in addition, the parties exchanged general releases.

Case in point:  Troy v. Carolyn D. Slawski, CPA, P.C., 2011 NY Slip Op 30476(U) (Sup Ct NY County Feb. 28, 2011), decided earlier this year by Manhattan Supreme Court Justice Judith J. GischeTroy involves a law firm of four brothers organized as a P.C. (professional corporation) which, as is typically done, elected for pass-through partnership tax treatment as a subchapter “S” corporation.  The plaintiff was a 25% shareholder of the P.C.  In 2007, the majority shareholders filed a dissolution proceeding which was resolved by a stipulation and order of settlement.  Under the stipulation, plaintiff received $150,000 in exchange for surrendering his interests in the P.C. and a real estate holding company also owned by the brothers.

The follow-up lawsuit was triggered by plaintiff’s receipt the next year of an allegedly “untruthful” K-1 from his former law firm allocating $75,000 net income to the plaintiff, which plaintiff denied receiving.  Plaintiff sued his former firm and his three brothers individually, alleging that the $75,000 was allocated to him to lower their own personal tax liabilities; that prior to plaintiff’s departure in 2007, the firm routinely made distributions to cover the partners’ personal taxes; and that the defendants were liable for the $25,000 in additional taxes owed by plaintiff on his reported K-1 income.  Plaintiff also sued the law firm’s accountant who prepared the firm’s 2007 tax return for breach of fiduciary duty and malpractice.

The accountant struck the first defensive blow, obtaining a ruling by Justice Gische in November 2009 (reported at 2009 NY Slip Op 32690) dismissing the fiduciary breach claims on the ground that no fiduciary relationship ordinarily exists between accountant and client.

The plaintiff subsequently moved for partial summary judgment against the law firm defendants, determining that they are obligated to reimburse plaintiff for the personal taxes due on the $75,000 he never received, based on the following provision in the 2007 stipulation of settlement in the dissolution case:

Upon surrender by Edward Troy of his shares of stock in the respondent [law firm] and [the real estate holding company] . . . the respondent will hold Edward Troy harmless for any liability for the payment of taxes or other debts of the respondent and [the real estate holding company] which exist December 31, 2007.

Justice Gische’s decision rejects plaintiff’s reliance on the provision and denies his motion.  The hold-harmless provision, she writes,

does not support plaintiff’s interpretation, that the defendants agreed to pay his personal income taxes.  The settlement agreement was made within the context of a corporate dissolution proceeding and the “taxes” clearly refer to corporate, not personal, taxes.

This does not end the case, which recently was certified as ready for trial.  Presumably among the surviving claims to be tried is plaintiff’s contention that the firm’s obligation to pay his personal taxes on phantom income arises from the firm’s allegedly longstanding, pre-dissolution practice of doing so.  (If that presumption is correct, I also presume that the parties did not exchange general releases as part of the stipulation of settlement of the dissolution case.)

The pass-through of phantom income is a common occurrence for closely held businesses that opt for partnership type taxation.  New York case law makes it fairly clear that owners of such businesses have no inherent right to demand payment by the company of their personal taxes on phantom income, and that any such right must derive from some form of agreement among the owners or pursuant to board directive.  Compare Deborah International Beauty, Ltd. v. Quality King Distributors, Inc., 175 AD2d 791 (2d Dept 1991) (enforcing shareholders’ agreement to make tax distributions) with Matter of Matco-Norca, Inc., 22 AD3d 495 (2d Dept 2005) (refusing to enforce tax distributions which were made discretionary, not mandatory, under terms of the shareholders’ agreement).

The ultimate lesson for counsel is to be sure to do a thorough tax analysis of any buy-out settlement, which may warrant involvement by a tax accountant.  Sometimes the tax impact is fixed and knowable as of the effective date of the buy-out, which tends to make the issue an easier one to resolve.  Often, however, the settlement is made mid-tax year or otherwise at a time that the company’s books have not yet been closed, raising the possibility that the selling shareholder may face an unknown future tax assessment on phantom income or, on the bright side, a future tax loss that may be used to offset other income.  Either way, counsel on both sides should be armed with the know-how to negotiate an appropriate tax provision as part of the settlement.

Update April 9, 2012:  On April 4, 2012, Justice Gische signed a Decision and Order (read here) denying the law firm defendants’ motion for summary judgment dismissing the complaint. The decision mostly addresses procedural issues of standing and “law of the case”, with little discussion of the merits. The decision does, however, mention one significant new fact: the stipulation resolving the dissolution proceeding included an addendum in which the parties expressly agreed that the stipulation “shall not bar Edward Troy from asserting a claim” against the law firm for “personal tax liability he incurred” from his 2007 K-1. That’s what’s known as kicking the can down the road.