Court Declines To Declare “S” Corporation Shareholders’ Agreement Unenforceable
Monday, July 27, 2015

In general, shareholders of a corporation that has elected to be taxed under Subchapter S of the Internal Revenue Code are taxed on corporate profits regardless of whether the corporation makes any distribution of those profits to its shareholders.  Obviously, paying taxes on income that isn’t actually received can be a problem for many shareholders.  Can the shareholders by agreement require the corporation to pay out at least enough to cover taxes?

One problem with such an agreement might be Section 300(a) of the California Corporations Code. That statute provides, with certain exceptions, that “the business and affairs of the corporation shall be managed and all corporate powers shall be exercised by or under the direction of the board.” Does an agreement to distribute moneys to pay taxes improperly invade the authority of the Board of Directors?

Section 300(b) seems to answer the question in the negative.  It provides in relevant part:

Notwithstanding subdivision (a) or any other provision of this division, but subject to subdivision (c), no shareholders’ agreement, which relates to any phase of the affairs of a close corporation, including but not limited to management of its business, division of its profits or distribution of its assets on liquidation, shall be invalid as between the parties thereto on the ground that it so relates to the conduct of the affairs of the corporation as to interfere with the discretion of the board or that it is an attempt to treat the corporation as if it were a partnership or to arrange their relationships in a manner that would be appropriate only between partners.

Casual readers of Section 300(b) may assume that the term “shareholders’ agreement” refers to any agreement among shareholders.  However, it has a much more limited meaning.  As defined by Section 186, a “shareholders’ agreement” means “a written agreement among all of the shareholders of a close corporation, or if a close corporation has only one shareholder between such shareholder and the corporation, as authorized by subdivision (b) of Section 300.”

The statute therefore doesn’t answer the question for most corporations, but one court has.  In Hubbard v. Phil’s BBQ of Point Loma, Inc., 2015 U.S. App. LEXIS 11781 (9th Cir. Cal. July 8, 2015), the Ninth Circuit Court of Appeals upheld the District Court’s award of damages for breach of a tax distribution agreement in a closely held, but not a close, corporation.

Phil’s BBQ was, for practical purposes, a close corporation because it had only three shareholders as well as severe limitations on the transferability of its shares.  Indeed, as conceded at oral argument, only one formality prevents Phil’s BBQ from falling squarely within § 158: Phil’s BBQ’s articles of incorporation failed to include a short statement that the number of shareholders cannot exceed 35 and that “[t]his corporation is a close corporation.” Cal. Corp. Code § 158.  Under all of these circumstances, we are unable to conclude that the contract would be held unenforceable as contrary to public policy.

The Court of Appeals, however, also determined that the opinion is not appropriate for publication and is not precedent except as provided by Ninth Circuit Rule 36-3.  Please see Federal Rules of Appellate Procedure Rule 32.1 regarding citation of unpublished opinions.

 

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