Ownership status in a closely-held business is the first and most vital box almost every business divorce petitioner must check.
Equity ownership is the sine qua non of many essential legal rights in the business divorce litigant’s toolkit, including standing to sue for dissolution, to sue derivatively on behalf of the entity, to bring a books and records proceeding, etc.
Evidence of Ownership in Business Divorce Cases
Proof of ownership status comes in many forms. It is surprising to some that the absence of stock certificates, on its own, “does not preclude a finding that a particular individual has the rights of a shareholder” (Zwarycz v Marnia Const., Inc., 130 AD3d 922 [2d Dept 2015]). Aside from stock certificates, courts may consider any and all “other available evidence” to determine “whether a putative shareholder in fact and law enjoys that status” (Kun v Fulop, 71 AD3d 832 [2d Dept 2010]).
What evidence do courts consider to determine ownership status? Courts look at many factors, including the exchange of consideration to acquire equity either in the form of cash or provision of labor, issuance of ownership certificates, corporate resolutions, meeting minutes, internal financial documents, loan documents and guarantees of corporate debt, the holding out to the public of individuals as owner or non-owner, etc. A wonderfully thorough treatment of these various “indicia” of ownership status is found in the post-trial, lower court decision in Matter of Pappas v Corfian Enters., Ltd., 22 Misc 3d 1113 [A] [Sup Ct, Kings County 2009], affd 76 AD3d 679 [2d Dept 2010].
And then there are tax returns, which have spawned an ever-expanding universe of litigation on the issue of the extent to which a tax return alone can prove whether an individual is, or is not, an owner of a closely-held business. This article will focus on two competing strands of New York case law, each rooted in a single New York Court of Appeals decision, one strand holding that tax returns are not determinative of ownership status in a closely-held business, the other holding that they are dispositive.
The First Strand – Heisler and its Progeny
The first strand of case law has its genesis in a Court of Appeals decision that did not address tax returns per se. In Matter of Heisler v Gingras (90 NY2d 682 ), the petitioner sued to confirm a disputed election of a board of directors under Section 619 of the Business Corporation Law (the “BCL”) (a proceeding only a shareholder may bring). The petitioner lacked any evidence of ownership except two “triennial statements” professional corporations must file under BCL § 1514. Petitioner argued, and both lower courts agreed, that the triennial statements listing him as shareholder “estopped” the corporation from contesting his ownership status.
The Court of Appeals reversed and dismissed the petition, explaining that “we reject any estoppel theory or analysis through which to resolve this case. Estoppel . . . should be generally inapplicable as bases to determine controversies of this kind.” The Court ruled that “the firm’s Business Corporation Law § 1514 filing, which lists petitioners as shareholders, is not in and of itself determinative of the problem presented by this case. While that filing is relevant and important in its own regulatory sphere and purpose, it is not intended to independently bind participants among themselves for the governance of the professional organization.”
There are a handful of Appellate Division decisions in the past decade or so adopting the reasoning of Heisler, applying it to tax forms, and holding that an entity’s filing with the government of tax returns identifying an individual as owner is not determinative “in and of itself” of ownership status:
- McGuire v McGuire, 197 AD3d 897 [4th Dept 2021] [“We agree with plaintiffs that the doctrine of tax estoppel does not preclude them from taking a position adverse to that stated in MDC’s tax forms”];
- Matter of In re Dissolution of Sunburst Assoc., Inc., 106 AD3d 1224 [3d Dept 2013] [“we note that the information contained in corporate filings, such as tax returns, is not necessarily dispositive”];
- Matter of Bhanji v Baluch, 99 AD3d 587 [1st Dept 2012] [“Flytime’s federal tax return for the year 2000, which indicated that she was a 50% owner of the corporation was insufficient, without more, to satisfy petitioner’s burden, since corporate and personal tax returns, even when filed with government agencies, are not in and of themselves determinative”]; and
- Matter of Cusimano v Strianese Family Ltd. Partnership, 97 AD3d 744 [2d Dept 2012] [“the doctrine of tax estoppel . . . is not applicable in this case. The record demonstrates that the partnership tax returns for the relevant years were prepared by a third-party accountant based solely on information provided to him by” one of the individual respondents].
Several recent lower courts decisions reach the same conclusion, finding tax returns to be some evidence of ownership status but not the end of the analysis, and which can be overcome by competing evidence (see e.g. Tradesman Program Managers LLC v Doyle, 2020 NY Slip Op 32452[U] [Sup Ct, Kings County 2020]; Barrison v D’Amato & Lynch, LLP, 2019 NY Slip Op 30905[U] [Sup Ct, NY County]; Lentini v 219 W. 20th St. Corp., 2018 NY Slip Op 32181[U] [Sup Ct, NY County 2018]; Friedman v Markowitz, 2016 NY Slip Op 32804[U] [Sup Ct, Nassau County 2016]; and Noryb Ventures v Mankovsky, 47 Misc 3d 1220[A] [Sup Ct, NY County 2015].
The Second Strand – Mahoney-Buntzman and its Progeny
The second, competing strand of case law has its genesis in a Court of Appeals case called Mahoney-Buntzman v Buntzman, 12 NY3d 415 , in which a husband received certain income from a business, which he characterized on his joint personal income tax return as ordinary income, but argued in the litigation was really a sale of stock constituting separate property, not marital property. The Court announced: “A party to litigation may not take a position contrary to a position taken in an income tax return.” The Court held,
Here, husband does not dispute that . . . he reported the $1,800,000 . . . as business income on his federal income tax return, in which he swore that the representations contained within it were true. We cannot, as a matter of policy, permit parties to assert positions in legal proceedings that are contrary to declarations made under the penalty of perjury on income tax returns.
There is now a growing body of Appellate Division case law firmly applying the doctrine of tax estoppel against individuals and entities taking positions contrary to those stated on tax returns, including one from just last week:
- Matter of Coven v Neptune Equities, Inc., 2021 NY Slip Op 05334 [2d Dept Oct. 6, 2021] [“Neptune’s S Corporation tax returns provided a Schedule K-1 reporting Walter as a shareholder. Neptune cannot take a position in this proceeding contrary to the position taken on its tax returns”];
- Kalaijian v Grahel Assoc., LLC, 193 AD3d 832 [2d Dept 2021] [“The evidence submitted by the plaintiff . . . demonstrated that since 2006, he held a 49% ownership interest in Grahel . . . . In opposition, the defendants, bound by the representations made in the partnership tax returns, failed to raise a triable issue of fact”] [citation omitted];
- Rizzo v Natl. Vacuum Corp., 186 AD3d 1094 [4th Dept 2020] [“By filing that election form, Lehr—who admitted that it was his signature on the form—[is] thereby estopped from denying Rizzo’s ownership interest”]; and
- PH-105 Realty Corp v Elayaan, 183 AD3d 492 [1st Dept 2020] [“The court improvidently exercised its discretion in failing to apply the doctrine of ‘tax estoppel.’ Under that doctrine, defendants’ acts in filing corporate tax returns for the years 2010 through 2014, signed by defendant Elayan, which contained factual statements that plaintiff Jaber had a 75% ownership interest in Edgewater during that time period, and precludes defendants from taking a position contrary to that in this litigation”].
Commentary on the Law
The legal landscape changed when the Court of Appeals decided Mahoney-Butzman, with many later courts inflexibly applying tax estoppel in business divorce cases against partnerships, corporations, and LLCs without much additional critical analysis. The irony is that Mahoney-Butzman was a matrimonial divorce not a business divorce, and a dispute over income not equity.
Other courts, though, still follow Heisler‘s rule that an entity’s governmental filing is not “in and of itself determinative” of ownership status and court should look to all of the evidence, not just tax returns, to reach the correct conclusion. How can one harmonize these two strands of case law?
A clue lies in PH-105 Realty Corp. In that case, the Court clarified Matter of Bhanji, its earlier decision declining to apply tax estoppel. The PH-105 Court explained:
To the extent our decision in Matter of Bhanji . . . has been interpreted as making the doctrine generally inapplicable with respect to factual statements of ownership in tax returns, we clarify that the doctrine applies where, as here, the party seeking to contradict the factual statements as to ownership in the tax returns signed the tax returns, and has failed to assert any basis for not crediting the statements.
Somewhat like an affirmative defense, a party opposing tax estoppel should be prepared to show that the tax filing either (i) was not signed or sworn by the party or on its behalf, or (ii) there is some factual “basis for not crediting the statements” in the filing.
This first prong recently defeated imposition of tax estoppel in McGuire v McGuire (“Tax estoppel does not apply where, as here, the relevant tax documents are neither sworn nor signed by the party against whom they are used”).
The second prong is trickier. What is a compelling “basis for not crediting the statements” in a tax return? There are any number of reasons why an entity might take a position on a return as to ownership that may not perfectly match the status quo in the business. Suffice it to say that to avoid imposition of tax estoppel, the party opposing the doctrine should provide a cogent, compelling reason for its decision to characterize information on the returns in the manner that it did, preferably with the corroboration of the accountant who prepared the return. We look forward to more case law fleshing out this particular defense to tax estoppel.