Going into business with other entrepreneurs can be, and should be, an important economic and personal opportunity for all involved. While it may not be a top priority at the outset, negotiating and putting together documentation of the ownership structure and rules of operation for the small business are essential steps that have many benefits, particularly in the event of an ownership dispute, economic hardship, outright business failure, etc., which ends up in litigation. The court battles tend to drag on for years, and the courts themselves seem to struggle to sort through the complex and controversy-laden histories, the competing expert valuations, the conflicting (or non-existent) company documentation, as well as the detailed statutes controlling some—but not all—of the parties’ rights and obligations. Results are far from predictable. For those interested in specific cases, an excellent blog on this subject can be found here.
Perhaps because of the complexity of these types of cases, there has been a trend in New York State courts to look solely to tax records to answer baseline issues in small business disputes: who are the owners, and how much of the business do they own? These seemingly simple questions get litigated over more than one may think. And while tax records may be good sources of evidence in some instances, courts’ growing reliance on them in business ownership disputes should give every small business owner pause, as well as a good reason to have a detailed discussion with accounting and legal professionals. One recent case out of Manhattan appears, to me, to highlight the dangers to small business owners (and their legal counsel) of failing to keep the business’s governance records consistent with filed business tax returns.
As very brief background, this legal trend picked up steam back in 2009, when New York’s highest court asserted that courts “cannot, as a matter of policy, permit parties to assert positions in legal proceedings that are contrary to declarations made under the penalty of perjury on income tax returns.” Mahoney-Buntzman v Buntzman, 12 NY3d 415, 422 . This judicial doctrine, referred to as “tax estoppel,” essentially prevents a party from taking a litigation position that is inconsistent with a tax return signed by that party, seemingly no matter the underlying facts and circumstances.
The recent case I mentioned earlier, PH-105 Realty Corp. et al. v. Munzer Elayaan et al., N.Y. County Index no. 656160/2016, involved a highly complex business ownership dispute and multiple business entities. The trial court had held that one of the alleged business owners had no interest in one such entity, a limited liability company (“LLC”) that owned waterfront property on Staten Island, because the undisputed evidence showed that he had never been listed as a member of the LLC in the company records, never made any monetary investments in the business, never specifically purchased an interest in the business, and never paid any of the carrying costs. Sounds pretty clear that he shouldn’t be entitled to call himself a business owner, right?
Despite all those undisputed facts, the would-be LLC owner presented company tax returns listing him as a 75% owner for tax years 2010–2014, though he was not so listed on the prior or subsequent years. He therefore sought to be declared a 75% owner under the “tax estoppel” doctrine. However, the trial court refused to apply “tax estoppel,” in light of the other undisputed evidence of the party’s lack of an ownership interest in the LLC, and also because and he had no explanation for appearing on some, but not all, of the LLC’s tax returns. A public copy of the trial court’s decision may be found here.
On appeal, the appellate court took a very different view. It found that the LLC tax returns for 2010–2014 showing the 75% ownership interest, along with the fact that the party challenging that ownership stake had signed those tax returns, required the application of “tax estoppel” as to those tax years, regardless of any other underlying facts. PH-105 Realty Corp v. Elayaan, 183 A.D.3d 492, 124 N.Y.S.3d 684, 685 (App. Div. 1st Dep’t, May 1, 2020). As a result, the would-be LLC owner was declared to be a 75% owner during 2010–2014, and was also permitted to pursue additional claims regarding his current ownership status.
My personal take is that by requiring the application of “tax estoppel” in this case, the appellate court took the position that all of the other undisputed evidence of the ownership structure of the LLC was inadmissible to the extent it was inconsistent with filed tax returns, and that the lower court “improvidently exercised its discretion” to even consider such evidence. I find this a bit troubling for at least two reasons.
First, business tax returns are generally prepared and filed by accountants or other non-legal personnel, who may not have this type of litigation at the front their minds. After all, the objective of tax return preparation is typically to minimize tax liability, not to prepare for a lawsuit that may occur two, three, five, or ten years from now (or never at all). Second, tax filings are generally intended to be highly confidential and not easily obtained by third parties even in litigation. But, if information on tax returns may be the only admissible evidence on issues of business structure and governance, shouldn’t the tax returns be required disclosures?
Circling back to my original point, it is therefore critically important that business owners ensure that both business and personal tax returns accurately reflect the business structure and written governance records. Attorneys, including many with this firm, can assist you to ensure that your business structure is accurately reflected in the tax returns, as well as negotiate and prepare the required intra-busines agreements and records, including: corporate shareholders’ agreements, LLC operating agreements, and partnership agreements (sometimes referred to as “buy-sell agreements”); documentation to formalize any employment terms and promises of future equity awards; and withdrawal and dissolution agreements, along with appropriate releases from liability, etc. If negotiated resolution is not feasible or forthcoming, we can also bring legal action on your behalf.
This post is intended to be used for informational purposes only. Legal advice is neither implied by the author nor should be inferred by the reader. If you have specific legal questions, you should consult with your attorney.
In his latest article Attorney Michael Frascarelli warns of a potential pitfall to minority stake business owners.