Do You Have a Reasonable Expectation of Receiving Dividends if You Acquired Your Shares in a Family-Owned Corporation Through Gift or Inheritance?

by Murtha Cullina

Corporate shareholders often expect to receive dividends in connection with their ownership of corporate shares. This is particularly true when owners invest capital in or provide other services to the company in exchange for their ownership interests.  But do shareholders’ rights to or expectations of dividends change when shares are acquired through gift or inheritance?  This issue frequently arises in family-owned businesses where shares are transferred from one generation of owners, who may have built the business through their investment of capital and labor, to the next generation, who themselves may never have worked in, or invested in, the business.

In Jones v. McDonald Farms, Inc., a Court of Appeals in Nebraska recently was presented with a claim by Diane Jones against her two brothers, seeking a decree of judicial dissolution of the company based on the brothers’ alleged “corporate oppression” through their failure to pay dividends to Diane in proportion to her share ownership.  Charles and Betty McDonald had incorporated McDonald Farms, Inc. in 1976.  Their two sons, Donald and Randall, began farming with Charles in the mid-1970s and they became officers of the company in 1989, while continuing to perform all farming duties.  From 1976 through 2010, Charles and Betty were majority shareholders and Donald and Randall were minority shareholders.  In 2010, Betty died and her shares were devised equally to her four children, including Donald, Randall, Diane and another sister, Rosemary.  In 2012, Charles gifted his stock equally to Donald and Randall.  Charles died in 2014.  As a result of these transfers, Donald and Randall each held 42.875% of the company’s stock, while Diane and Rosemary each owned 7.125% of the stock.

The company had converted from a subchapter S corporation to a subchapter C corporation in 1993. According to the testimony of the company’s CPA, “Charles’ desire was to pay as little in taxes as possible in order to build the size of the corporation.”  To do so, Charles worked with the CPA to keep the company’s annual taxable income around $50,000 in order to take advantage of a 15% corporate tax rate.  In order to achieve this income level, the company carefully timed the purchase of new business equipment and the sale of crops.  In certain years, notably 2010, 2012 and 2013, the company also paid “commodity wages” to Charles, Donald and Randall, through which they received transfers of grain or other commodities in lieu of cash in exchange for their services to the company.  According to the CPA’s testimony, by paying commodity wages instead of cash, the company could avoid paying Social Security and Medicare taxes.  Before 2010, Donald and Randall had never taken any salary for working for McDonald Farm, even though they could have.  The CPA testified that the commodity wages in these three years was not excessive given the number of years they had worked without pay.  Donald and Randall also never received any dividends during the period before 2012 when they were still minority owners.

Diane sued Donald and Randall, along with the company, asserting claims of “corporate oppression” through which she alleged that her brothers “denied her any economic benefit from her shares while attempting to force her to sell her shares below their fair value.”

In January, 2012, Diane offered to sell her shares of the company for approximately $240,000. Donald and Randall, who by that point comprised the company’s directors and majority owners, declined the offer but instead offered to purchase Diane’s shares for around $47,000.  No agreement was ever reached for the sale of Diane’s shares.  Instead, Diane sued Donald and Randall, along with the company, asserting claims of “corporate oppression” through which she alleged that her brothers “denied her any economic benefit from her shares while attempting to force her to sell her shares below their fair value.”  On appeal, the Appeals Court noted that Diane “is essentially challenging McDonald Farms’ tax strategy” and complaining that, instead of attempting to reduce its taxable income through the payment of commodity wages and timing of other business purchases, the company “should maximize its income and pay dividends to its shareholders.”

The Appeals Court affirmed the trial court’s ruling in the brothers’ favor, noting that “the evidence presented at trial established that there is nothing inherently inappropriate about [the company’s] tax strategy or decision not to pay dividends.” In support of this conclusion, the Court highlighted that a corporation is not required to pay dividends to its shareholders under the applicable Nebraska corporate statute.  (While it is important to review the relevant state corporation statute and any applicable restrictions in a company’s articles of organization, along with state and federal tax requirements, the Nebraska statute making dividend payment discretionary is similar to other states’ statutes, including Massachusetts.)  The Court also noted that the company had never paid dividends and instead had consistently operated in a manner designed to best reduce taxation.  Through this strategy, the company’s appraised value was over $9,000,000 as of 2012 when Diane inherited her 7.125% share of the company. The Court further commented that, even though Diane had no involvement whatsoever in the operation of the family farm, the value of her 7.125% share of the company was over $640,000 by 2012 “and continues to grow each year.”

In response, Diane argued, and one dissenting Appeals Court Judge agreed, that the company’s payment of commodity wages to Donald and Randall “denied the minority shareholders their reasonable expectations of sharing in the profits.” The Appeals Court rejected this argument, first by questioning “whether the reasonable expectation standard applies to minority shareholders who have acquired their shares by gift or devise, because the test involves assessing the reasonable expectations held by minority shareholders ‘in committing their capital to the particular enterprise.’” Even if the reasonable expectation standard did apply, the Court noted that “oppression should be deemed to arise only when the majority conduct substantially defeats expectations that, objectively viewed, were both reasonable under the circumstances and were central to the [minority shareholder’s] decision to join the venture.”

The Court found that “based upon the history of the company, the minority shareholders had no reasonable expectation that profits would be paid out to them.”

In this case, the Appeals Court noted that Diane did not make any capital investment in the company, but instead she inherited her shares from her mother. Further, the company had never, since 1976, paid dividends to minority shareholders. Also, the Court confirmed the trial court’s finding that the company had not paid any commodity wages between the date Diane acquired her shares in 2010 and the date she first offered to sell her share to the company in 2012.  Thus, Diane’s claim that the payment of commodity wages to Donald and Randall violated her reasonable expectation of dividends was “suspect.”  Instead, the Court found that “based upon the history of the company, the minority shareholders had no reasonable expectation that profits would be paid out to them.”

The Court cautioned that it was not ruling “that that the majority shareholders can retain all profits to themselves if doing so constitutes oppression.” The Court further referred to a comment in the trial court’s decision that “it is quite possible that the continuation of payment of commodity wages without the payment of dividends to shareholders would result in [a finding that the brothers deprived Diane of any return on her share], but based upon the evidence as was presented, the evidence at this time does not support a finding of oppression.”  On the record before it, therefore, the Appeals Court determined there was no reason to overturn the trial court’s finding that Diane had failed to prove her claim for judicial dissolution based on any oppressive conduct.  As a result, the company would remain intact, and not dissolved, with Diane continuing as a minority shareholder after appeal.

The McDonald Farms case serves as a reminder that, in the context of privately-owned family businesses, the shareholders’ rights to dividends and other benefits of ownership often will depend on their reasonable expectations, based at least in part upon their capital investment, if any, in the company.  Where a stockholder has acquired his or her shares by gift or inheritance, instead of in exchange for a capital investment or performance of services, there may be no reasonable expectation to share in the profits of the company, particularly if the company has never distributed profits to minority shareholders before the shares are gifted or inherited.  Nonetheless, the right of an inheriting minority owner to any distributions will depend on the particular facts and circumstances.  Specifically, even if there have never been distributions before, the majority owners still may be liable for distributions if they are found to have unfairly retained for themselves, through payment of wages or otherwise, all the benefits of ownership.

Where disagreements arise concerning rights of minority shareholders to payment of dividends, the parties would be well-advised to try to negotiate a resolution among themselves, through, for example, a purchase of the minority owner’s shares or an agreement providing for increased involvement by the minority owner in the capitalization or management of the company. Otherwise, if forced to decide the issue, a court in equity may issue a ruling after trial that makes either continuing co-ownership of the family-owned business or further discussions among the owners about any stock purchase or sale much more difficult.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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