Family FeudThe road to a business divorce can be a long and litigious one, strewn with obstacles big and small, limited only by the cleverness of the business owners and their counsel as each side strives to gain superior bargaining leverage against the other in anticipation of the inevitable buyout or other separation agreement.

The jousting can be especially intense in a business divorce between family members. The cost/benefit calculus that normally moderates tactics in and out of court is often warped by the intense emotions characteristic of a litigation pitting parent against child, sibling against sibling, cousin against cousin, and so on.

There’s a case pending in the Suffolk County Commercial Division, Margiotta v Tantillo, Index No. 62839-2013, that exemplifies the extraordinary demands upon the court’s resources as it’s called upon repeatedly to grant various forms of interim relief to one side or the other in a hotly contested family business divorce.  A pair of recent decisions in the case by Justice Emily Pines also highlights the limitations upon the court’s power to grant interim relief when it comes to requests for mandatory injunctive relief, that is, requiring a party to perform some positive act as opposed to restraining them from doing something.

The stakes in Margiotta include a number of auto dealerships and the real properties on which they operate. The business was founded and controlled by the family patriarch, Anthony Tantillo, who died in 2013 at the age of 82. During his lifetime Mr. Tantillo brought into the business and gave minority interests to two children from his first marriage. He also brought into the business a stepson from his third marriage. His will left most of his estate to his two natural children and appointed one of them his executor. Possibly unknown to his two natural children until after his death, he also executed documents or entered into transactions that gifted company shares or otherwise gave majority ownership of several of the operating and realty companies to his stepson.     Continue Reading Court Denies Mandatory Injunctive Relief in Battle for Control of Family Business

Think of it this way: At every negotiation of a shareholder buyout involving an S corporation or other passthrough entity, there are three parties at the table — the seller, the buyer, and the IRS.

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]. Continue Reading Negotiating a Buyout? Don’t Overlook Taxes on Phantom Income

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]. Continue Reading Stock Redemption Agreement Forecloses Seller’s Suit for Tax Liability on Phantom Income

A recent decision by Vice Chancellor Donald F. Parsons, Jr. of the Delaware Chancery Court in Duff v. Innovative Discovery LLC, C.A. No. 7599-VCP (Del Ch Dec. 7, 2012), garnered much attention primarily for its holding that Section 18-111 of the Delaware LLC Act (“Interpretation and Enforcement of Limited Liability Company Agreement”) gives Chancery Court, which generally functions as a court of equity jurisdiction, subject matter jurisdiction even over lawsuits essentially seeking money damages arising from the alleged breach of a Delaware LLC operating agreement.

But that’s not what I want to talk about. What caught my eye was the underlying dispute over a tax-related provision in a February 2012 redemption agreement under which two members of a Delaware LLC sold their membership interests back to the company. At issue was the former members’ personal income tax liability for that portion of the LLC’s 2011 net income allocated to the former members on their form K-1’s but not distributed to them.

This is not the first time I’ve written about how the issue of taxes on “phantom” income can bedevil owners of interests in pass-through entities who sell their interests without ascertaining and negotiating protection against subsequent net income allocation on their K-1 in excess of amounts actually received by them. In August 2011 I wrote about a New York case where the selling 25% shareholder under a buy-out agreement involving an S corporation unsuccessfully sued for reimbursement of his personal income taxes on $75,000 phantom income. The buy-out agreement included no provision for indemnification of such taxes and no buyer warranty that the seller’s future K-1 would exclude phantom income.

Unlike that case, in Duff the parties thought about the issue and included in the LLC membership redemption agreement a provision addressing the selling members’ future K-1’s. The problem — at least according to the sellers in their subsequent lawsuit — was that the provision as drafted did not jibe with the parties’ intent to protect the sellers against taxes on phantom income for the prior and current tax years. Continue Reading Delaware Case Provides Drafting Lesson for “Phantom” Income Provision in Buy-Out Agreement

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.

Continue Reading Beware Taxes on Phantom Income When Entering Into Shareholder Buy-Out Agreement