I’ve written before (here and here) about the need to address potential tax liability of the selling shareholder on “phantom” income, i.e., undistributed net income allocated to the shareholder on his or her Form K-1, when entering into a buy-out agreement. The issue commonly arises when the buy-out occurs mid-tax year or at any time before the corporation’s books are closed and returns completed for the tax year in which the buy-out occurs and for any prior tax year. The seller, no longer in a position to review or influence the post-transaction tax returns, effectively may end up underwriting the taxes on retained earnings for the benefit of the remaining owners. (It’s a different story if the corporation is reporting and allocating losses on the K-1’s which, ordinarily, the selling shareholder is quite content to receive.)
The case law generally views the issue through a contract lens. In other words, absent provision in the buy-out agreement for reimbursement of tax liability on phantom income, there’s no inherent, common-law right to a tax distribution to a former shareholder after the buy-out’s consummation.
The general rule takes on even greater potency when the buy-out agreement contains provisions effectively waiving the shareholder’s rights to seek additional monies coupled with a merger clause, which is what happened in a case decided last month by the Manhattan-based Appellate Division, First Department, called Jia v Intelli-Tec Security Services, Inc., 2014 NY Slip Op 01384 [1st Dept Feb. 27, 2014].
The plaintiff in Jia is the widow of Marty McMillan, a co-founder of a Long Island-based security systems integrator known as Intelli-Tec. McMillan died in 2008. In 2010, the plaintiff as administrator of her husband’s estate entered into a letter agreement with Intelli-Tec (read here) under which the estate redeemed its shares for $400,000.
In 2013, the plaintiff on the estate’s behalf sued Intelli-Tec and its two remaining owners, claiming they reneged on promises to reimburse the estate for taxes on phantom income allocated on its K-1s following McMillan’s death through 2010. The complaint (read here) alleged that the company had always made tax distributions while McMillan was alive and working for the company, and that following his death the defendants assured plaintiff, while they were negotiating the stock redemption agreement, that they would “deal separately” with the tax reimbursements. The complaint’s two causes of action for breach of contract and fraud, respectively, sought reimbursement for the estate’s $137,000 tax bill and rescission of the redemption agreement or damages for the “true value” of the shares .
The Dismissal Motion
The defendants moved to dismiss the complaint, arguing that the redemption agreement made no promise to reimburse the estate for its tax liabilities. Their defense also rested on Section 1 of the redemption agreement, stating that the estate “sells and delivers” the shares “free and clear of any and all liens, covenants, restrictions, options or other rights whatsoever . . . in exchange for $400,000 in cash,” and the standard merger clause in Section 5, stating:
This Agreement represents the entire understanding and agreement between the parties hereto and supersedes any prior understanding, agreements or representations by and between the parties, written or oral, with respect to the subject matter hereto.
The trial court, in a September 2013 decision by Manhattan Supreme Court Justice Eileen A. Rakower, dismissed the complaint’s fraud claim but kept alive the contract claim (read here). As to the fraud claim, the court held that the plaintiff’s allegations, that defendants “lured” her into selling the estate’s shares at a “reduced price” with a false promise to cover the estate’s tax liabilities via a separate “arrangement,” were “flatly contradict[ed]” by the redemption agreement’s omission of any such promise coupled with its merger clause. As to the contract claim, Justice Rakower found that the complaint adequately pleaded a cause of action based on the alleged existence of an agreement among all the shareholders, while McMillan was alive and active in the company, that Intelli-Tec would pay them, in addition to their salary and benefits, an annual amount to cover their tax obligations arising from non-distributed pass-through income.
The Appellate Ruling
Both sides appealed, but only the defendants emerged victorious from last month’s unanimous First Department ruling. The court held that both of the plaintiff’s claims warranted dismissal based on the language in Sections 1 and 5 of the redemption agreement. Wrote the court:
[Defendants] were entitled to dismissal of the complaint as the documentary evidence flatly contradicts both causes of action. The alleged agreement to reimburse the estate for tax liabilities arises from the estate’s status as a shareholder. Thus, any such agreement was extinguished when the estate sold its shares free and clear of all other rights and would have been superseded pursuant to the letter agreement’s merger clause. Additionally, plaintiff’s representation in the merger clause forecloses her reliance upon any representation not contained in the letter agreement and cannot serve as a basis for her fraud claim. [Citations omitted.]
It’s difficult to draw conclusions about what happened in the Jia case. The papers filed by the plaintiff with the lower court, including plaintiff’s own affidavit (read here), don’t reveal if legal counsel assisted her with the negotiation and drafting of the stock redemption agreement, although it’s apparent that tax liability on phantom income was a concern of the plaintiff at the time. It also strikes me as odd that the redemption agreement didn’t specify the percentage interest of the estate’s stock holding, suggesting a dispute over its percentage interest. In any event, Jia serves as another warning to selling shareholders and their counsel contemplating buy-out agreements that, unless the agreement expressly provides for reimbursement, an unpleasant and costly surprise may await when the K-1 arrives in the mail.