Why the IRS? The commonly understood answer, even to those lacking tax expertise, is the seller’s liability for capital gains tax on buyout proceeds in excess of the seller’s basis in the shares.
Less appreciated, especially to those without tax expertise, but potentially of equal or even greater financial impact, is the seller’s liability for ordinary income taxes on undistributed a/k/a phantom income that may be reported on his or her Form K-1 issued by the passthrough entity after the buy-out closes for a tax period that preceded the buyout. For this type of tax liability, think of the IRS as a tax allocator which, at the direction of the remaining shareholders who control the company’s tax reporting, will reduce some portion of their personal income tax liability by allocating undistributed net income to the selling shareholder who will be forced to pay ordinary income taxes on phantom income. While this also should reduce the seller’s capital gain on the sale by increasing basis in the shares, overall the seller loses because of the significantly higher tax rates on ordinary income versus capital gains.
This is a topic I’ve written about several times before, featuring cases in which the seller’s release barred a post-buyout suit seeking reimbursement for taxes on phantom income (read here) or where the seller relied unsuccessfully on tax provisions in the buyout agreement that didn’t support indemnification of taxes on phantom income (read here and here). Add to this collection a case decided last month by the Appellate Division, First Department, which handed the selling shareholder a double defeat by finding that his release barred his claim to recover taxes on phantom income and also ordering him to pay attorneys’ fees incurred by the corporation and its majority shareholder defending the seller’s suit under the buyout agreement’s indemnification provision. Sina Drug Corp. v Mohyuddin, 2014 NY Slip Op 07757 [1st Dept Nov. 13, 2014].
The Buyout Settlement
The factual background of the case is laid out in the lower court’s November 2013 decision by Manhattan Commercial Division Justice Shirley Werner Kornreich. Briefly, in 2006 Mohammad Ali Mohyuddin brought suit in Nassau County Supreme Court against his former employer, Sina Drug Corp., and its majority shareholder, claiming he was entitled to receive equity in the company as part of his employment compensation. In 2010 the court granted summary judgment for Mohyuddin, holding that he owned 18% of the company. The company appealed and stayed enforcement by filing with the court an 18% share certificate in lieu of undertaking. In 2011, while the company’s appeal was pending, the parties entered into a settlement agreement (read here) whereby Mohyuddin relinquished his equity in exchange for $3.8 million on which he paid approximately $570,000 in capital gains tax. The settlement included a separate Release, Disclaimer and Indemnity containing mutual general releases and an indemnity provision requiring Mohyuddin to indemnify the company and its majority shareholder for any liability or expenses, including attorney’s fees, incurred defending any post-settlement claims brought by Mohyuddin within the scope of his release.
New Litigation Follows the Company’s Issuance of K-1s
In July 2011, about two months after the settlement closed, the company filed amended tax returns for the years 2007-2010 and issued Mohyuddin Form K-1s for those years allocating to him about $1.27 million representing 18% of the company’s net income, none of which was distributed to Mohyuddin. Presumably, the remaining shareholders also received amended K-1s reflecting a proportionate reduction of their net income allocations, also presumably entitling them to tax refunds on their amended personal returns.
In October 2012, Mohyuddin filed a new lawsuit against Sina Drug and its majority shareholder in which he sought to recover damages in the amount of any taxes, interest and penalties to be assessed on account of the K-1s (read complaint here). Mohyuddin alleged that, neither pursuant to the 2010 court ruling nor the 2011 settlement were any shares actually issued to him. Since he never owned any shares, the complaint reasoned, the company’s issuance to him of K-1s was improper.
In December 2012, the company removed the suit to federal court alleging federal question jurisdiction. According to a later transcript in state court proceedings, sometime in 2013 the federal court dismissed the complaint for lack of standing because Mohyuddin did not allege injury, i.e., hadn’t yet paid taxes on the phantom income.
Meanwhile, in July 2013, Sina Drug and its majority shareholder filed suit against Mohyuddin asserting his liability under the 2011 settlement’s indemnity provision for their attorney’s fees and other expenses incurred in defending against Mohyuddin’s post-settlement lawsuit challenging the K-1s.
Both sides moved for summary judgment. The company’s brief (read here) argued that the claim asserted in Mohyuddin’s post-settlement lawsuit regarding taxes on phantom income fell within his release and therefore triggered his contractual indemnity obligation to pay defense costs. Mohyuddin’s brief (read here) argued that the company itself breached the settlement agreement by forcing Mohyuddin to sue on account of the improper K-1s, and in any event was premature pending a judicial determination of the propriety of the tax controversy.
Justice Kornreich’s November 2013 decision dismissed the complaint on the ground that the company’s contested issuance of the K-1s occurred subsequent to the settlement agreement, therefore Mohyuddin’s post-settlement lawsuit challenging the K-1s fell outside the scope of the indemnity provision. In so ruling she expressly declined to make any determination of the legality of the K-1s issued to Mohyuddin.
The Appellate Ruling
The company appealed to the Appellate Division, First Department, whose decision last month found, without further analysis, that Mohyuddin’s post-settlement lawsuit “was barred by the terms of the valid release which extinguished any claims regarding Mohyuddin’s tax liability.” The court then went a step further, holding that the company’s “actions in issuing the schedule K-1 statements were not improper,” adding:
Prior to the settlement, Mohyuddin was judicially determined to be an 18% owner of plaintiff Sina Drug Corp. during the stated period, and as a subchapter S corporation, Sina Drug is required to issue schedule K—1 statements reflecting each shareholder’s ownership, regardless of whether the income was actually distributed. Moreover, we find that nothing in the contractual language of the parties’ release suggests that plaintiffs intended to relieve defendants of any tax consequences. [Citations omitted.]
The court then upheld the company’s indemnity claim, writing:
Plaintiffs are entitled to attorneys’ fees they incurred in defending the action commenced by Mohyuddin since the indemnification provision in the parties’ settlement agreement unambiguously reflects defendants’ expressed intent to indemnify and hold plaintiffs harmless from and against all claims or expenses in connection with any claims brought by defendants.
The decision’s sole, saving grace for Mohyuddin was its finding that the settlement agreement’s provision for $1 million liquidated damages in the event of his refusal to indemnify the company was an “unenforceable penalty.”
The Takeaway. The peculiar facts in the Sina Drug case, in which the seller took the position that he never obtained shareholder status and therefore didn’t expect to be issued K-1s at all, don’t lend themselves to any broad pronouncements. As I’ve written before, in any buyout negotiation, whether friendly or in settlement of litigation, counsel must do a thorough tax analysis which often will warrant consultation with a tax accountant. The seller’s counsel especially must be attuned to tax consequences for any open tax period in anticipation of receiving a new K-1 for the most recent year, or an amended K-1 for prior years, after the settlement has been consummated. My tax partner extraordinaire, Lou Vlahos, offered these additional insights:
The company’s annual income is allocated on a per-day-per-share basis; any income allocated to the seller will increase his basis in the shares being sold, thereby reducing his gain from the sale. The income so allocated is based upon the S Corporation’s income for the entire year. Thus, for example, a portion of the gain from a corporate liquidity event in which the seller did not participate, because it occurred after his departure, nevertheless will be allocated and taxed to the seller (under the per-day-per-share rule). One way to protect against this is to include a purchase price adjustment for subsequent liquidity events. In addition, well-advised sellers will negotiate for the closing of the corporation’s books as of the date of the stock sale so as to avoid the allocation of post-sale-date income to the seller; anything that occurs after the sale of his shares will not impact him tax-wise.