Closely-Held Corporation Buy-Sell Agreements, Stock Valuation and Protection of Minority Shareholders
This case involves a stock purchase agreement (buy-sell) for a family-owned Iowa S-Corporation. The agreement provided that when the parents passed away, the son who was taking over the family business would acquire all outstanding shares of common stock. If the son exercised the option, the personal representative of the decedent was required to sell the decedent’s shares at the price established under the agreement. The agreement stated that the purchase price was to represent the “fair market value” of the shares. An addendum to the purchase agreement provided the method of calculating the fair market value. The closing of the stock transaction was to take place at a date “mutually agreed upon by the parties, which shall be not more than 90 days following the date of the exercise of such option.” The father died in 2000 and the son exercised his option and purchased all of his father’s shares at $6,517 per share. The fair market value of the shares was calculated based upon the profit reflected in the corporation’s actual tax returns. No one disputed this method of calculation.
The mother owned a substantial amount of the corporate stock at the date of her death in 2006. The son exercised his option to purchase his mother’s remaining stock in a timely manner, as required by the purchase agreement. The son initially offered to pay $6,622 per share based upon the calculations of the company’s accounting firm. It was later discovered that the firm made an error in the calculation, so the son increased his offer to $8,175 per share. The son used the same method of valuation as he did when he bought his father’s stock. The estate rejected the offer and claimed that the fair market value was $28,251 per share. The estate argued that the son had taken inappropriate tax deductions for travel and entertainment expenses, executive compensation, and uneconomic leasing arrangements. Thus, they argued that the calculation of fair market value using the “profit or loss, as determined for Federal income tax purposes” was unfair.
The son filed suit asking the court to order the estate to comply with the purchase agreement. At trial, the attorney and the accountant for the corporation testified that the purpose of the stock purchase agreement was to readily and efficiently determine the purchase price and maintain continuity of the family business. The accountant further testified that the purpose of the agreement was to “freeze the value” of the business and that the best way to determine the value of the shares was to look at the corporate returns and the books and records of the corporation.
The estate’s expert, however, testified that the payout should be over $24,000 per share because the tax returns substantially understated the true profits due to the unsubstantiated tax deductions.
Thus, the basic dispute for the court to resolve was whether the purchase price of the shares should be based upon the actual tax reporting in previous years as opposed to a retrospective analysis of what should have been reported. At trial, the court ruled that the parents merely intended for the purchase price to be calculated using the information that was available in the tax returns. The clear intent was to avoid disputes of this kind. Thus, the son’s offer was approved.
The estate appealed and the Iowa Court of Appeals addressed the fair market value issue stating that stock purchase agreements are subject to the ordinary principles of contract law. The court did agree that the phrase “profit or loss, as determined for Federal income tax purposes” had the potential for ambiguity. However, the court found the son’s interpretation more logical and compelling. The court opined that “tax advice is an art rather than a science, and one can always debate the propriety of certain past deductions.” The court found that the estate’s interpretation was unwieldy and they did not offer a readily ascertainable formula. The purchase of shares from the father’s estate established a prior course of dealing and the practical construction of the purchase agreement was the fairest way of settling the dispute here.
While the court upheld the application of the stock valuation formula, it ruled against the son on another aspect of the case. Because the corporation was a subchapter S corporation, there is no tax at the corporate level. Tax is only triggered when the corporation passes corporate income through to the shareholders. Many S corporations (and limited liability companies) distribute sufficient income for the shareholders to pay the tax on the corporate income that is distributed to them. But, that is not always the case. Indeed, in this case while the dispute concerning the valuation of the stock continued (for over three years) the mother’s estate incurred tax liability on its share of corporate income. However, the son (while acting as co-executor with his sister – he later withdrew) prevented the corporation from continuing its longstanding practice of distributing enough income to the estate to cover the estate’s tax liability. So, the estate had income, but not enough income to benefit very much (if at all) because of the tax incurred on that income. The estate claimed that the son’s actions violated his fiduciary duty to the estate – the estate had tax liability while simultaneously the son would benefit from the profit on the estate’s shares. The court agreed, holding that the son’s actions constituted bad faith and oppressive conduct, and that the son had to add state and federal taxes that the estate had to pay on post-July 2006 profits to the amount the son had to pay for the stock.
The case carries out an important point for practitioners drafting buy-sell language for closely-held corporate stock: include language that requires the corporation to distribute enough income to cover the tax liability until the value of the stock is determined and the shares are actually purchased via the agreement. Lee v. Meloan, No. 0-286/09-1328 (Iowa Ct. App., Jun. 30, 2010).