Shareholder disputes are time-consuming, expensive and counter-productive. Shareholders disputes are easy to avoid, if you agree on basic principles before shareholders come together as business partners. The basic principles include-

1. Who does what jobs.
2. Who gets paid what and when. (I include a provision to cover taxes.)
3. What happens if someone stops working or completing their job duties.
4. What happens if there is a buy-sell “triggering event” such as death, divorce, dissolution of the entity, disability, etc.
5. How elections are held to select company leaders.

The key to solving shareholder disputes is to AVOID them in the first place through buy-sell agreements, operating agreement and similar documents. Do NOT form your business partnership without addressing these issues IN WRITING AT THE START.

One final thought. . . pick your partners well. I have myself had to endure difficult and unreasonable business partners. So, trust me when I urge you to be cautious in selecting your partners. Assume each partner will be unreasonable at some point.

And get it in writing at the start!

Before I can define “phantom income,” I’ve first got to explain how “tax flow through entities” work.  Basically, if you own at least part of a partnership, limited liability company or S-corporation, you get a a tax bill each year based on your share of the business’ profits.  That bill comes in the form of a K-1 tax form, which shows your portion of the profits or losses.

So, if you own 40% of a company (for the entire tax year) that had $100,000 of profits in 2008, then you would get a K-1 for $40,000.  If you only owned that 40% for half the year, your K-1 should report $20,000 of imputed income to you.  You then have to report that income on your individual income tax return and pay taxes on that amount.

But wait!  What if the company never paid you a distribution (a/k/a dividend) equal to your K-1 number?  Or, what if the company only pays you $12,000, but your K-1 shows $40,000 of income?  If that happens, you have have “phantom income.”  So, even though you only received a distribution of $12,000, you have to pay income taxes on the full $40,000.

If you want to avoid paying taxes on “phantom income,” then you should consider an agreement among all the owners and the company requiring the company to distribute at least enough profits to cover the taxes on your “phantom income.  When I draft these agreements for my clients, I like to include a provision requiring no less than 40% of the company’s profits to be distributed, which should normally be enough in distributions to cover the highest marginal tax rate on any one owner.  I include an exception, in the event the company has anticipated cash flow issues, or is about to make a large expenditure and needs the cash.

If you fail to include such a provision in your agreements, then you run the risk that the majority owners might try to “freeze out” the minority owners by causing “phantom income” to be reported on the minority owner’s K-1, year after year after year.  In that case, it actually costs money for the minority owners to own a share of a profitable company.

.

A buy-sell agreement (“BSA”) is a great document.  BSA’s can be used for corporations, limited liability companies and partnerships.  Often, a BSA is embedded in the Operating Agreement of an LLC or the Partnership Agreement of a general, limited or limited liability partnership.  The form of a BSA is far less important than are its contents.  So, don’t get confused by the name of the agreement.  Rather, consider the purpose and content of a BSA.  I’ll write about the substance of BSA’s in a future blog.  Here, I want you to consider WHY you should consider a BSA for your business partnership.

BSA’s serve several important purposes, such as these:

• A BSA can prevent disputes over control of a company.

HOW?  A well-written BSA establishes when and how one owner may or must buy the ownership of another owner.  If disputing owners know the outcome of their power struggle, they are less like to fight.  The end result is already decided.  Generally, people fight, when they believe they can make gains through the process.  BSA’s reduce the opportunities to gain through struggle, and thus reduce disputes/lawsuits.

• A BSA creates a market for your ownership interests.

HOW?   There is no market to sell partial ownership interests in most small companies.  There is no stock exchange for such “closely-held” companies.  A BSA can create a market by requiring one owner to  buy the other owner’s shares under certain circumstances, which we call “triggering events.” 

    “Triggering events” are bad things that can happen to any business owner.  The key triggering events are: 

• The death of an owner.
• Marital divorce.
• The disability of an owner.
• Unwillingness of an owner to continue the business.  I call this “disinterest.”
• Retirement by an owner.
• Dissolution of the company.

• A BSA can further your Asset Protection Plan.

HOW?   Under certain circumstances, a BSA can make it extremely difficult for the creditors of an company to get at the ownership interests of an owner.

• A BSA enables you to keep your company longer.

HOW?   If your partner “triggers” your buy-sell agreement, you can agree in the BSA to a payment plan.  So, in other words, if you have to pay $80,000 to buy your partner’s ownership interests, the BSA can provide for terms.  Typically, you agree to a down-payment, a modest interest rate on the balance and payments over time.  That enables the “buying” owner to keep the business going, rather than being forced to sell the company or key company assets.  Having to buy-out your partner is an extraordinary expense.  A BSA can make those payments manageable.

• Much, much more.

There are other advantages to BSA’s.  There are also disadvantages.  Whether a BSA is right for you depends on a number of factors.  Your CPA and attorney can help you determine if and how a BSA should be used.