Minority Shareholders: Withholding of Dividends and the Tax Burden it Creates

Throughout this series we will detail some of the common methods that majority shareholders use to destroy a minority shareholder's value in the company and what rights a minority shareholder has when this happens. In this post we address a majority shareholder's attempt to "squeeze" a minority shareholder out of the company by retaining earnings in the company rather than paying dividends.

"Squeezing" Minority Shareholders Out

As stated above and referenced in the last post in this series Wrongful Termination & Tortious Interference with Business Relations, once a majority shareholder has terminated a minority shareholder's employment in the company, it can then begin to force the minority shareholder out of the company by refusing to declare dividends the minority shareholder in an attempt to "squeeze" them out of the company.

As alluded to earlier, one of the problems for minority shareholders in a corporation is that they lack the power to declare or not declare dividends. Instead, this voting power rests with the majority shareholder. A majority shareholder can easily abuse this power in an attempt to force the minority shareholder out of the company.

Subchapter S Corporations

This method can be effectively used in a Subchapter S corporation or LLC. For those who have never heard of a Subchapter S corporation, or any other types of corporation for that matter, here is a quick summary:

Election of Subchapter S status allows a corporation to pass its tax liability to each shareholder proportionate to his share interest in the company. The simple way of explaining this benefit is that this can result in a type of tax break for the shareholders of the company if their individual tax rates are lower than the corporate tax rate.

Rather than be taxed at the higher corporate rate, shareholders can tax their profits at the lower individual rate, saving money. This avoids what is known as "double taxation." Obviously as individual tax rates rise this may not be profitable, and there are other factors to consider, but the decision to enter or not enter into Subchapter S status is beyond the scope of this article.

The Squeeze-Out Technique 

If no dividends or other distributions are made to the minority shareholder in a Subchapter S corporation or LLC, they are nevertheless required to pay taxes on the corporate income despite not receiving any of the income to help meet the tax obligation. Thus, the squeeze-out technique has been recognized in Georgia where a majority shareholder attempts to force a minority shareholder out of the company by withholding dividends without a legitimate corporate purpose.

As majority shareholders can control the decisions to declare dividends and assign salaries to corporate employees, the majority shareholders can freeze all corporate income while continuing to pay themselves salaries and other benefits and not paying the minority shareholder a salary or benefits. Once the minority shareholder has been excluded as an employee, the majority shareholders may choose to award themselves bonuses and higher salaries, diverting company funds that would usually be dividends into their own pockets.[1]

Once the minority shareholder starts to feel the burden of the tax obligation, but is not receiving any money from the corporation, their value in the company becomes essentially worthless at best and a huge detriment at worst. The majority shareholder will then try to buy, or "squeeze-out," the minority shareholder at a fraction of what their shares are actually worth.

Protection Against Squeezing - Fiduciary Duty

Fortunately, Georgia courts have identified these actions as a breach of fiduciary duty to the minority shareholder. A majority shareholder is required to deal in good faith with minority shareholders and protect their interests. Georgia case law states,

The Georgia Supreme Court went on to state that because the minority shareholder's "own interests [were] depreciated and used to render him ineffective and 'freeze" his investment,' such action demonstrated a lack of good faith.

Yet another method by which majority shareholders can breach their fiduciary duty to minority shareholders is to increase the number of shares available in an effort to diminish the minority shareholder's ownership interest and share value.

Identifying Breach of Fiduciary Duty

Now, it is important to recognize that not all actions by the majority shareholder that happen to disadvantage the minority shareholder are to be considered breaches of fiduciary duty. Georgia law states that a "claim for breach of fiduciary duty requires proof of three elements: (1) the existence of a fiduciary duty; (2) breach of that duty; and (3) damage caused by the breach."[3]

In determining whether there has been a breach of the duty by the board or majority shareholder, Georgia law employs what is known as the "business judgment rule" to determine whether or not a majority shareholder has breached his or her duty. Georgia law demands that

In simpler language, this means that a judge will not find the withholding of dividends by the board of directors automatically wrongful, but will instead look to whether they had adequate reasons for doing so. This gives the board wide discretion to choose to not declare dividends, as long as its decision is not arbitrary, fraudulent, or in bad faith.[6]

A company may decide to withhold dividends for several valid reasons, but where there is evidence of a history of dividends being issued prior to the termination of the minority shareholder in addition to large bonuses and compensation to officers in lieu of dividends, a court may likely find that there has been a breach of fiduciary duty and a failure to meet the requirements of the business judgment rule.

A court will examine several factors to determine whether a board is justified in not declaring dividends, including the "corporation's present and prospective financial needs," "special interests of the majority not shared by the minority," and the "amount of surplus, the ratio of current assets to current liabilities, the amount of working capital, business prospects, [and] the need for expansion."[7]

Understanding Your Rights as a Minority Shareholder

A healthy understanding of your rights as a minority shareholder is vital to your, and your company's, continued success and profitability. In order to avoid the situation detailed above, it is important to keep abreast of your company's organizational and financial information. As majority shareholders attempt to squeeze you out of the company, they will try to keep this information from you, a situation that we will cover in the next post - "Minority Shareholders: Right to Corporate Records."