- The most straight-forward way of protecting a minority shareholder’s economic stake in a closely-held corporation is to require the payment of dividends.
- In most small corporations, dividends are never paid because all profits are distributed to the owners in the form of employment compensation. This is why the loss of employment is the usual mechanism for shareholder oppression.
- However, shareholders are free to agree in a shareholder agreement to distribute profits by means of dividends. In a Sub-S corporation, such a policy would have no negative tax consequences; although in a C corporation, dividends are subject to double taxation.
Structuring a Dividend Agreement
Great care must be taken in structuring a dividend agreement. By statute corporations are prohibited from paying out dividends in excess of profits or that would make the corporation insolvent. Directors who vote for illegal distributions are personally liable to the corporation. As a practical matter, corporations frequently need excess capital for many legitimate business reasons – such as maintaining a working capital reserve, investing in capital spending, paying debts – that would limit or preclude the payment of dividends. A diffident requirement runs the risk of severely injuring the corporation at a business level. A carefully crafted dividend provision in a shareholder agreement might deal with most of those issues through various formulas; however, it is almost impossible to anticipate every circumstance in which the payment of dividends might be injurious to the corporation, and the more latitude given to the board, the less protection against oppressive conduct.
Moreover, dividends are paid out of profits, and profits can be easily manipulated. Majority shareholders can readily decrease the amount of profit available for distribution by increasing salary and bonuses to themselves and their allies. One solution would be to require that shareholder-employees work for no salary, but dividends only. That solution is likely to be unfair and resisted in practice because it would be a rare situation when the value of the services each shareholder contributes to the enterprise exactly matches the percentage ownership of shares. Another solution would be to provide for set base salaries that could be changed only with unanimous consent and to pay the profits out in dividends.
To discuss your NJ shareholder matter, please contact Fredrick P. Niemann, Esq. toll-free at (855) 376-5291 or email him at fniemann@hnlawfirm.com. Please ask us about our video conferencing or telephone consultations if you are unable to come to our office.
By Fredrick P. Niemann, Esq. of Hanlon Niemann & Wright, a Freehold Township, Monmouth County, NJ Shareholder Attorney