There are many ways in which majority shareholders can oppress minority shareholders, from “squeeze-outs” and “freeze-outs” to refusing to pay dividends to minority shareholders when they are owed. Suppressing dividends is one problem that is often accompanied by majority shareholders providing additional benefits to themselves through constructive dividends.
When majority shareholders give themselves benefits through the payment of constructive dividends, it may be further evidence of minority shareholder oppression, and minority shareholders who have been adversely affected may be able to make a claim for payment of constructive dividends.
If you have questions about minority shareholder oppression and suppressed dividends, you should learn more about claims for payment of constructive dividends by speaking with a Texas business litigation attorney as soon as possible.
What is a Constructive Dividend?
Before getting into the ways in which constructive dividends are involved in minority shareholder oppression, it is important to understand what constructive dividends are and why they are able to result in oppressive actions against minority partners or shareholders.
The term “constructive dividend” is a tax term that the Internal Revenue Service (IRS) uses to describe distributions to shareholders that are not treated by the business or corporation specifically as dividends (or profits), but are still considered to be dividends for tax purposes. When shareholders receive distributions from the business, the IRS essentially distinguishes dividends from loans.
If a distribution does not have the characteristics of a loan (which in theory needs to be repaid), then the IRS is likely to treat the distribution as a dividend that is taxable—even if it is not described or defined as such. This type of taxable distribution is what typically constitutes a “constructive dividend.”
How about under Texas law? In the Texas Supreme Court case Ramo, Inc. v. English (1973), the court explained that “whether or not a corporate distribution is a dividend or something else, such as a loan, gift, compensation for services, repayment of a loan, interest on a loan, or payment for property purchased, presents a question of fact to be determined in each case.”
Alluding to the distinction drawn by the IRS, the Ramo Court clarified that “the crucial and controlling question is whether the advances were loans or dividends.” In Legrand-Brock v. Brock (2008), the Court of Appeals of Texas further clarified that “a distribution by a corporation to its shareholders may constitute a dividend in law even though not formally designated as a dividend by the board of directors.”
In other words, Texas law has affirmed the general definition of a constructive dividend provided by the IRS. While the goal of the IRS in defining a constructive dividend is primarily to determine whether that business distribution should be taxed, there are other reasons to define this kind of distribution under Texas law.
Specifically when it comes to minority shareholder oppression, whether or not a distribution is a constructive dividend or a loan can mean the difference between a majority shareholder action that is oppressive and one that may not be.
How is the distribution of constructive dividends a form of minority shareholder oppression? Generally speaking, a majority shareholder can distribute corporate funds—without defining them specifically as dividends—to other majority shareholders.
In so doing, the majority shareholder distributing the funds can enrich himself or herself, along with other majority shareholders, while preventing minority shareholders from obtaining dividends that they may be due.
Under the Texas Supreme Court case of Ritchie v. Rupe (2014), it is very difficult for minority shareholders who do not have a shareholder agreement or contract to have a remedy for this kind of minority shareholder oppression.
Under Ritchie, in order to prove that minority shareholder oppression has occurred and for the minority shareholder(s) to have a remedy, the minority shareholder has the burden of proving this definition of oppression: “[A] corporation’s directors or managers engage in ‘oppressive’ actions . . . when they abuse their authority over the corporation with the intent to harm the interests of one or more of the shareholders, in a manner that does not comport with the honest exercise of their business judgment, and by doing so create a serious risk of harm to the corporation.
As the Texas Supreme Court case of Cardiac Perfusion Services, Inc. v. Hughes (2014) shows, it is very difficult to prove each of these elements of oppressive actions, and minority shareholders after Ritchie are limited in their available remedies even when it is clear that a majority shareholder overpays himself in dividends while refusing to pay dividends to minority shareholders.
Indeed, as the dissent in Ritchie articulated, “typical acts of minority oppression (refusing to pay dividends, paying majority shareholders outside the dividend process, and making fire-sale buyout offers) usually operate to benefit the corporation and hardly ever harm it.”
Remedies for Failure to Pay Dividends and Constructive Dividend Payments
Minority shareholders may be able to file a claim for breach of fiduciary duty or breach of trust in cases where majority shareholders have been unjustly compensated through constructive dividends. For example, in Yeaman v. Galveston City Co. (1911), the Court of Appeals of Texas made clear that corporations have a fiduciary duty to hold a shareholder’s dividends and to pay those dividends when the shareholder demands them.
In order to make a successful claim for constructive dividends, under Ritchie, a minority shareholder must be able to show:
- Majority shareholder(s) received excessive salaries through misappropriation of corporate funds; and
- Majority shareholders refused to declare dividends.
As the Ritchie Court highlights, “shareholders . . . have a right to receive payment of a declared dividend in accordance with the terms of the shares and the corporation’s certificate of formation, and they can enforce that right as a debt against the corporation.”
It can be complicated to prove that additional distributions to minority shareholders were not loans or payment for services, or other distributions that are not characterized as dividends, but a Texas business litigation attorney can help.
Discuss Your Case with a Business Litigation Attorney in Dallas
Are you a minority shareholder who is owed dividends? Do you believe majority shareholders in your business were excessively compensated through constructive dividends? A business litigation attorney in Dallas can help with your case. Contact Lindquist Wood Edwards LLP to get started on your case.