Have you ever heard a story among your friends about a company where two partners got along great, but then one suffered an untimely death and then his widow or children caused the company to breakup? That is a common scenario, although one might not be able to place the blame on the surviving spouse or the children. This is one of the ultimate worst case scenarios that proper planning can help avoid.
As shareholders in a small company each shareholder may have a reasonable expectation of continuing employment and participation in management of the company. When one shareholder dies, unless an agreement among the shareholders is in place providing a right for the company or remaining shareholder to purchase the deceased shareholder’s stock, that stock will be transferred to that deceased shareholder’s heirs, whether by will or by intestacy. As a result, most often the deceased shareholder’s stock ends up in the hands of a surviving spouse or children. In some cases the heir of the deceased shareholder will be able to step into his or her shoes and be able to participate meaningfully in the operation of the business. There may be personality conflicts and other difficulties in operating the business with a new partner, but hopefully, those can be worked out.
More often, however, the deceased shareholder’s stock is inherited by someone who does not have any clue about the business and cannot be expected to participate in or contribute to the operation of the business in any realistic sense. Sometimes this leads the remaining original shareholder to think that he will not pay them a salary since they are not working in the business and he can retain the earnings to reinvest in the business since he is not required to pay dividends. This is a recipe for disaster and some really unfortunate consequences.
The inheriting shareholder may not have any reasonable expectation of earning a salary in the business or having a role in the management of the company, but he or she does have a reasonable expectation of an opportunity to earn a return on their investment. This reasonable expectation includes the payment of dividends by the company when funds to do so are reasonably available. Moreover, in the event of a deceased shareholder, if the inheriting shareholder cannot be said to have a reasonable expectation of employment by the company, then the courts can impose an obligation on the remaining original shareholder to provide some monetary benefits to the inheriting shareholder in lieu of that salary. This was the scenario encountered in the court in Bonavita v. Corbo, 300 N.J. Super. 179 (Ch. Div. 1996).
In Bonavita the deceased shareholder had stopped working 3 years before his death, but continued to receive a salary equivalent to the other shareholder until the date of his death. Almost ten years earlier the deceased shareholder had asked the surviving shareholder to buy his shares, but after some discussions they could not reach an agreement. The inheriting shareholder did not work in the company and was, therefore, not paid a salary. The surviving shareholder thereafter refused to pay the inheriting shareholder any dividends and also refused her request to buy out her interest in the company. The surviving shareholder’s wife and four children also worked in the company and between them received between $300,000 and $400,000 in salary and fringe benefits while the inheriting shareholder received nothing at all. In reviewing this case the court found that because the inheriting shareholder had no children and was in her 80s, she had no expectation of employment or benefit from long term growth of the company and that the only benefit she had a reasonable expectation of receiving was the payment of dividends. Accordingly, the court found that the refusal to pay dividends constituted oppression and required the surviving shareholder to buy the stock of the other shareholder.
This type of situation can best be avoided by proper planning that is executed when all parties are of similar mind. It is much easier and cheaper to negotiate a fair and reasonable Buy/Sell Agreement when it could easily apply to either party than it is to deal with the failure to have any such agreement in a lawsuit or when circumstances have changed and one party thinks it has an advantage over the other.