Iowa Supreme Court Determines “Fair Value” of Stock in Farm Corporation Buyout

On June 18, 2021, the Iowa Supreme Court released an opinion involving the proposed buyout of two shareholders of a family farm corporation. After the two plaintiffs petitioned for judicial dissolution, the corporation sought to buy their shares at fair market value. The Iowa Supreme Court found that the transaction costs for asset liquidation should be included in the valuation. Conversely, because this was an S corporation, the Court ruled that potential capital gains liability would create a second tax and thus should be excluded.

Background

Three siblings jointly owned their family farm corporation. The brother owned 52.5 percent of the corporate shares with his two sisters each owning 23.75 percent. In 2017, the two sisters brought this lawsuit seeking judicial dissolution of the corporation alleging their brother engaged in oppressive conduct. They also sought damages for breach of fiduciary duty. The corporation, under Iowa Code section 490.1434, elected to buy the sisters’ shares at fair market value. The brother filed for summary judgment on the breach of duty claim.

The district court held a hearing after the siblings failed to agree on the fair market value of the shares. Because the assets of the S corporation comprised mostly farmland, the district court used the “net asset value” method to determine the value of the corporation. After subtracting the corporation’s liabilities from its total assets, the district court valued the corporation at $5,782,357 and value of each sister’s shares at $1,373,327. The court ordered the purchase of the sisters’ ownership through a five-year payment plan and granted the sisters’ request for attorney fees and other expenses. Lastly, the court granted the brother’s motion for summary judgment, finding that the sisters did not meet their burden in showing the alleged breach of fiduciary duty caused an injury to the corporation, rather than the sisters individually. Both parties appealed the fair market value determination.

Determination of Fair Market Value of Corporate Shares

A shareholder may petition for judicial dissolution if the directors or a controlling shareholder acts in a manner that is illegal, oppressive, or fraudulent or misapplies or wastes corporate assets. Iowa Code § 490.1430(1)(b). However, a corporation may avoid dissolution by purchasing all of the petitioner’s shares at “fair value.” Iowa Code § 490.1434(1).

“Fair value” is not defined in § 490.1434 and can be difficult to ascertain when the stock is in a closely-held business. Both parties urged the use of the net asset value method, as opposed to the “market value” or “investment value” methods, because most of the corporation’s value came from farmland rather than income generation. Noting that this method provides protection to minority shareholders in corporations with substantial assets but low earnings, the Court also decided to use this methodology to consider whether the district court properly determined the corporation’s value.

Decrease of Fair Market Value due to Transaction Costs and Capital Gain Tax Liability

On appeal, the brother claimed that the district court erred when it failed to discount his sisters’ shares for transaction costs in a potential sale of assets. The district court found that transaction costs of a liquidation sale are generally not part of a corporation’s value and any potential asset liquidation was theoretical. However, while differing on the exact amount to discount, both parties’ expert witnesses agreed that these transaction costs should be included in the valuation.  Persuaded by the expert testimony, the Court concluded that the district court erred by failing to apply a discount for transaction costs.

The brother also appealed the district court decision to exclude potential capital gain taxation from the valuation. A “built-in gain” tax is collected on the appreciation of an asset. 26 U.S.C. § 1374(d)(1). The appreciation of an S corporation that has converted from a C corporation includes the difference of the current fair market value and the value at the time of conversion. The corporate assets, especially the farmland, had appreciated substantially since the corporation converted from a C corporation to an S corporation in 2007. The brother argued that failing to discount a potential tax on the appreciated assets unfairly placed the burden solely on him to pay the tax at any future sale.

In this instance, the Court found that hypothetical tax implications differed from the assumed transaction cost of a sale. As an S corporation, tax is paid at the shareholder level rather than the entity level. Therefore, the sisters would be taxed individually on the appreciated stock value upon sale. Discounting the stock value for future capital gains taxation for sale of the farmland would, in essence, create a double tax.

Additionally, the Court noted that the brother could avoid taxes on capital gains by passing his shares to his children upon death who would then receive a basis step-up to fair market value of those shares. Through strategic planning, the tax implications could be avoided or mitigated if the underlying asset, the farmland, was never sold. In reaching its decision that no discount should be applied for hypothetical capital gains tax, the Court also relied on evidence of the fact that there was no intent by the controlling shareholder to sell the land. Allowing a deduction for hypothetical capital gains tax, the Court opined, could encourage majority shareholders to elect to purchase a petitioning shareholder’s stock at a discount, but avoid the tax by keeping the property.

Increase of Fair Market Value due to Misuse of Corporate Assets

The sisters also argued on appeal that the district court erred in failing to account for their brother’s alleged wasted and misapplication of corporate assets when valuing the company. Unlike a direct action where the shareholder brings a claim for her own personal injuries, a shareholder uses a derivative action to bring a claim on behalf of the corporation for injuries sustained as a shareholder.

Agreeing with the district court, the Supreme Court found that these were derivative claims brought on behalf of the corporation. The sisters’ claim of misapplication of assets alleged harm to the corporation. Because of that, the claim was a derivative action which requires specific procedural requirements which the sisters had not followed. See Iowa Code § 490.742; Iowa R. Civ. P. 1.279.

Attorney and Expert Fees and Expenses

Lastly, the Court considered whether district court erred in awarding the sisters attorney fees and expert costs. Attorney fees are only recoverable under statute or under a contractual provision. The district court may award attorney and expert fees and expenses to a petitioning shareholder under Iowa Code § 490.1430 if the petitioner has “probable grounds for relief” in the form of a dissolution because of oppressive conduct. Iowa Code § 490.1434(5). Oppressive conduct includes waste or misapplication of corporate assets.

The Court found that the district court ruled that the brother misapplied corporate assets by renting corporate land to himself for less than the market rate; distributing and repaying loans from the corporation to his personal entities, and trading land between the corporation and himself. While this might not qualify as waste, the district court had found that the brother misapplied corporate assets for his personal benefit. This was sufficient conduct to trigger a fee award.

The Court also affirmed the award of fees and expenses against the corporation, even though the brother was the only alleged bad actor. A petitioning shareholder is not required to include shareholders in a dissolution proceeding. As such, the Court found that the fee statute contemplated that the corporation was the party responsible to pay any fee and expense award.

Special Concurrence

Justice Oxley wrote a special concurrence, agreeing with majority’s judgment, but disagreeing on the majority’s analysis of the capital gains issue. Oxley wrote that the tax consequences of a hypothetical sale must be included in the valuation of a corporation. She reasoned that whether the sale was contemplated or imminent was not determinative, but rather whether any resulting gain would be taxed at the entity level. Here, because the entity was an S corporation, not taxed at the entity level, Justice Oxley agreed with the result.