Chicago Business Litigation Lawyer Blog
In closely held companies, particularly LLCs and corporations with a limited number of shareholders, the issue of compensation for owners and shareholders can be a legal minefield. A significant concern arises when majority owners, often also serving as executives, award themselves excessively high salaries or compensation. This practice, while appearing to be a clever business strategy, can veer into illegality, particularly if it’s done with the intent to minimize or avoid distributions to minority owners.
Understanding the Legal Framework
The legal principles governing such practices are rooted in the fiduciary duties that majority shareholders or LLC owners owe to minority stakeholders. These duties include the duty of loyalty, which mandates that decisions must be made in the best interests of the company and all shareholders, not just a select few.
When majority owners inflate their compensation unjustly, they may be breaching this duty. This is especially true if the inflated salaries negatively impact the company’s profitability or the ability to pay dividends or distributions to other shareholders.
Case Law and Legal Precedents
Various legal precedents highlight this issue. Courts have often scrutinized such practices under the lens of fairness and the fiduciary duties owed. For instance, in cases where the majority shareholders’ salaries are disproportionately high compared to the company’s overall financial health or industry standards, courts have found this to be a breach of fiduciary duty.
In cases such as Fleming v. Louvers International, Inc., courts have found that depriving a minority shareholder of his rightful pro rata distributions through excessive compensation can constitute a breach of fiduciary duty. Another case, Kovac v. Barron, identified a shareholder who committed constructive fraud by causing the corporation to pay him and his wife millions in excessive compensation, which was then concealed as “contract labor” on tax returns.
Certain regulations also provide guidance on this matter. For instance, compensation exceeding the costs that are deductible as compensation under the Internal Revenue Code are deemed unallowable for owners of closely held companies. The Small Business Administration (SBA) views the payment of excessive officers’ salaries as a type of withdrawal from a company, implying that the SBA may see such actions as an attempt to avoid excessive withdrawal limitations.
The Balance Between Fair Compensation and Minority Rights
It’s important to note that not all high salaries for majority owners are illegal. Compensation must be evaluated in the context of the individual’s role, contributions, and industry standards. The problem arises when there’s a clear intent to siphon off profits that would otherwise be available for distribution to all shareholders, particularly minority ones.
Legal Remedies for Minority Shareholders
Minority shareholders who suspect foul play have legal avenues to challenge such practices. This can include demanding fair compensation practices or, in extreme cases, pursuing legal action for breach of fiduciary duty.
Best Practices for Closely Held Companies
- Transparency: Ensure that compensation decisions are transparent and justifiable.
- Benchmarking: Regularly compare compensation packages with industry standards.
- Shareholder Agreements: Clearly outline compensation and distribution policies in shareholder agreements.
- Legal Counsel: Consult legal experts to ensure that compensation practices align with legal obligations and best practices.
Conclusion
In conclusion, while it’s critical for closely held companies to compensate their key stakeholders fairly, this must be balanced with the rights and interests of minority shareholders. Excessive compensation to avoid distributions can lead to legal troubles, highlighting the importance of ethical and transparent business practices.
For a free consultation regarding any shareholder or LLC litigation matter contact us online or at 630-333-0333.