De facto dividend. Disguised dividend. Constructive dividend. They all refer to the same thing: monies in excess of reasonable compensation taken by owners of closely held companies, booked as deductible employment compensation rather than as a non-deductible distribution from profits. For companies taxed as C corporations — as opposed to S corporations and other pass-through entities taxed as partnerships — because they are paid from after-tax income, declared dividends effectively are subject to double taxation at the company and shareholder levels.
The tax laws thus provide no small incentive for owners of closely held companies to pay themselves, shall we say, generous compensation in lieu of declaring and paying dividends. This being a blog about disputes between business co-owners, I approach the topic not from the standpoint of tax compliance but, rather, to address how de facto dividends can surface in business divorce litigation as fodder for allegations of oppressive conduct by majority shareholders against minority shareholders.
De Facto Dividends as Potential Tools of Oppression
There are a number of scenarios that give rise to disputes over real or imagined de facto dividends.
One of the most common ones occurs with companies all of whose owners are employed in the business. Often because of the above-mentioned tax incentives, the companies declare no dividends while the owners take salaries plus periodic or year-end bonuses of any excess cash as employment compensation. The problem arises when one or more of the owners is forced out by the others without any recourse or buyout rights under a shareholders agreement. The ousted shareholder no longer receives a salary and the company continues its no-dividend policy while the remaining owners split among themselves the ousted shareholder’s former compensation and/or use it to hire a replacement worker if needed. The ousted shareholder (or LLC member) is left high and dry financially, with no income from a company he or she still owns and, if it’s a pass-through entity, having to go out of pocket to pay personal income taxes on any phantom income reported on their K-1s.
Another common scenario involves closely held entitles with both active and passive owners — a very common pattern with family-owned businesses with second, third or subsequent generation ownership. The outside owners, who may or may not be looking for grounds to force a buyout of their interests, may come to believe they are being shorted on profit distributions because the insiders are paying themselves excessive compensation.
Little or No New York and Delaware Case Law
There are not many New York cases I’ve found that analyze in depth allegations of de facto dividends as constituting oppressive conduct by majority shareholders in lawsuits seeking judicial dissolution. In the one New York case I’ve blogged about in the last 15 years in which allegations of de facto dividends were prominent — Feldmeier v Feldmeier Equipment, Inc. — the plaintiff resigned from the family-owned firm amidst hostility with his siblings after many years working there. He later filed a suit for common-law dissolution, alleging that the remaining active family members were paying themselves excessive compensation as de facto dividends while he received nothing. The appellate court upheld dismissal of the suit, finding that the defendants “demonstrated that there was no misconduct by the individual defendants when they continued the established practice of paying bonuses to officers, who were also shareholders.”
When New York precedent is sparse I usually default to Delaware, but not this time since (a) Delaware does not have a minority shareholder oppression statute and (b) as Chancery Court noted some years ago in Quadrant Structured Products Co. v Vertin, “Delaware law does not recognize a claim for constructive dividends.”
Recent Maryland Case Offers Guidance
Filling the void, along comes a recent decision by the Appellate Court of Maryland — that state’s intermediate appellate court — in Mekhaya v Eastland Food Corp. The case was brought by a 28% shareholder, officer and director of a second-generation, family-owned food importer and distributor. In 2018, soon after the plaintiff’s brother was elevated to President and amidst disagreements over several important business issues, the plaintiff was fired from his $400,000 salaried job and removed as a director.
The plaintiff alleged that at a shareholder meeting shortly before his removal, they discussed undertaking a “dividend study” to consider shareholders getting dividends based on ownership instead of receiving salaries “as if they were dividends.” The plaintiff alleged that after his ouster, the remaining directors abandoned the idea and, in ensuing years, refused to pay dividends from profits while paying his siblings “excessively high salary and other compensation.”
The plaintiff pleaded a statutory claim for minority shareholder oppression, alleging that by terminating his employment, removing him from the board, refusing to pay dividends, and paying themselves excessively high salaries, the defendants frustrated the plaintiff’s reasonable expectations. His complaint sought appointment of a receiver, injunctive relief, and compensatory damages.
The defendants moved to dismiss the complaint, invoking the business judgment rule and arguing that the plaintiff’s ouster and their decision not to declare dividends were not oppressive absent any shareholder or employment agreement conferring those rights on him.
The trial judge granted the dismissal motion, finding that there was “no confirmed basis that [the claimed dividend] was ever viewed as dividend or that the salary was viewed as dividend in this matter,” or any expectation that dividends would be paid. Plaintiff appealed from the order of dismissal.
The appellate court launched its legal analysis with a thorough review of the principles animating the reasonable-expectations test for oppression, its application, and the equitable remedies available upon a finding of oppression. It’s too lengthy to quote here. Suffice it to say that the discussion could just as well have been written by a New York court summarizing that state’s jurisprudence surrounding the reasonable-expectations test adopted by the New York Court of Appeals in its 1984 landmark opinion in Matter of Kemp & Beatley, Inc.
The opinion then framed the key question before it as follows:
The question we ask ourselves, therefore, is whether the de facto dividend claimed by Mekhaya, or the majority shareholders’ refusal to expressly declare a dividend, could be an objectively reasonable expectation by him, according to the circumstances set out in the complaint. If so, we ask then whether the majority shareholders’ actions defeated substantially that expectation and whether Mekhaya’s requested relief was within the circuit court’s powers to grant.
Noting a “dearth of Maryland law that touches on the de facto dividend claim,” the opinion embarked on a detailed examination of the federal tax code and regulations concerning constructive dividends, followed by a cross-country tour of decisions from five state and three federal courts. Not surprisingly, none of the cases hales from New York or Delaware.
Drawing from those decisions, the court disagreed with the trial judge’s rationale for dismissal, explaining:
[T]he question is not whether Mekhaya’s expectation in receiving a de facto dividend as part of his salary was ever “confirmed” or expressly declared as a dividend by Eastland. The question, rather, is whether Mekhaya’s complaint, on its face, alleged facts sufficient to establish that his expectations as a shareholder were reasonable (when viewed through an objective lens) and that Appellees defeated substantially one or more of those expectations.
The court answered its own question affirmatively, writing:
Mekhaya’s complaint advanced such a showing. As noted earlier, Mekhaya’s flagship allegation was that, as a shareholder, he expected to share in company profits by receiving a de facto dividend as part of his salary. That expectation was reasonable, despite the fact that Eastland never declared officially a dividend. Thus, when Appellees terminated Mekhaya’s employment and stopped paying his salary, thereby depriving him of the de facto dividend portion, arguably Appellees defeated substantially Mekhaya’s asserted reasonable expectation as a shareholder. Those allegations are sufficient to state a claim for shareholder oppression. Again, whether Mekhaya can prove those facts is immaterial to the stage of these proceedings as they reach us here.
In addition, Mekhaya alleged that, following the termination of his employment, Eastland’s board of directors continued to refuse to declare expressly a dividend, despite the fact that Eastland was “quite profitable.” According to Mekhaya, instead of declaring a dividend, Eastland’s board chose to pay “excessively high salaries” to Oscar and Vipa. Those actions, if proven, could be considered shareholder oppression, particularly if the majority’s actions left Mekhaya with a “worthless asset.”
The court’s opinion also disagreed with the trial court “[t]o the extent [it] may have believed that it lacked an appropriate remedy under the circumstances” in the form of an order requiring distributions or awarding damages. Here’s what it said:
[I]f Mekhaya can prove that Eastland had been paying a “constructive” or “de facto” dividend to its shareholders, employees or directors, that he reasonably expected to receive that benefit, and that Appellees defeated substantially that expectation, the court has the power to order “affirmative relief by the required declaration of a dividend or a reduction and distribution of capital” and award “damages to minority stockholders as compensation for any injury suffered by them as the result of ‘oppressive’ conduct by the majority in control of the corporation.” [Citation omitted.]
You won’t be surprised to know there was no shareholders agreement among the plaintiff and his siblings. As far as lessons to be drawn from the case, I begin with the most fundamental one: every multi-owner, closely held business needs a comprehensive, thoughtful, professionally drafted, constitutive agreement binding present and future owners. The agreement should include reasonable protections for minority owners concerning major events and reasonable buy-sell provisions contemplating payment of fair value to a departing shareholder while not unduly impinging upon the finances or operations of the company.
It would be extremely hubristic on my part to offer one-size-fits-all advice on how to fix owner compensation and what dividend policy to adopt in closely held companies. There are far too many variables and company-specific factors, many of which fall in the realm of the company’s tax accountant.
What I can say is that managers/owners of profitable companies with a no-dividend policy should give serious consideration, before the outbreak of shareholder dissension and certainly afterward, to engaging the services of an accredited professional who can perform an independent reasonable-compensation analysis to assist management in determining whether the company and/or its owners are at risk (a) of the IRS assessing taxes, penalties and interest based on constructive dividends, and/or (b) of an ousted or inactive owner suing for oppression or asserting derivative claims based on payment of excess compensation and perquisites to insiders.