- Form K-1s Do Not Always a Shareholder Make
- May 29, 2013 | Author: Peter A. Mahler
- Law Firm: Farrell Fritz, P.C. - New York Office
One of my all-time favorite quotes is from a 2009 decision in a case called Matter of Pappas in which the court had to sift through a pile of contradictory, ambiguous and incomplete documents and testimony to determine the ownership of several closely held corporations. Justice Jack Battaglia hit the nail on the head when he wrote in that case:
In the real world, particularly that in which close corporations operate, clear evidence of share ownership is often not found in the corporate books and records, for any number of reasons.
In the “real world,” inattention to, misunderstanding of, or, in some cases, the deliberate falsification of share ownership records explains why there are so many corporate dissolution cases in which the threshold issue is the petitioner’s standing to seek dissolution. The petitioner who lacks a stock certificate, stock ledger or written shareholders’ agreement conclusively memorializing stock ownership, may be forced to rely on other evidence of ownership to refute the respondent shareholder’s contention that petitioner is a pretender.
In such cases corporate tax returns can play a critical role, particularly with subchapter “S” corporations that file partnership tax returns including form K-1s that identify each shareholder and state his or her ownership percentage. A dissolution petitioner who never received K-1s, but who knows or ought to know that the corporation filed partnership returns, may have great difficulty overcoming a defense of lack of standing. Likewise, a respondent shareholder who signed a corporate return that included a K-1 reporting the petitioner’s share ownership may find it impossible to establish a standing defense.
But not always, as evidenced by an appellate ruling earlier this month in Matter of Sunburst Associates, Inc., 2013 NY Slip Op 03368 (3d Dept May 9, 2013).
Sunburst is a quirky case involving a company that operated a small chain of tanning salons in upstate New York. It was not disputed that the petitioner, Vilardi, and the respondent, Babbino, founded the company in 1995 as 50/50 shareholders and operated it as co-equal owners for the next 12 years. In July 2007, the two of them entered into some sort of transaction — the nature and effect of which were hotly disputed in the lawsuit — in which Vilardi endorsed his stock certificate over to Babbino in escrow but they also signed an agreement stating that Vilardi’s status as a shareholder was unchanged. A month later, however, the two signed another document, which Vilardi claimed was meant only to be used for purposes of securing corporate credit, stating that Babbino was sole shareholder.
Vilardi brought a deadlock dissolution proceeding under § 1104 of the Business Corporation Law. Babbino sought to dismiss the petition on the ground Vilardi was not a shareholder and therefore lacked standing to bring the proceeding. At the trial in 2010, Vilardi offered copies of unsigned corporate tax returns including K-1s for the years, 2007, 2008 and 2009 all of which identified Vilardi and Babbino as 50/50 shareholders. Babbino testified that he signed the 2007 return, and that in each of those years he filed personal returns including his own K-1s showing 50% ownership. Babbino nonetheless denied the returns reflected the true ownership, stating that Vilardi and the person who prepared the returns were “very good friends” and that Babbino tried to correct the returns upon discovering the “mistake.”
The trial judge issued a one-page order finding that Babbino was the company’s sole owner. Vilardi appealed to the Appellate Division, Third Department, which issued a decision in March 2012 stating that the absence of findings in the trial court’s ruling “foreclosed” appellate review, and remanding the case to the trial judge to make additional findings and to render a new decision.
Two months later, the trial judge entered an order adhering to its original finding that Vilardi did not own any shares at the time he commenced the dissolution proceeding and dismissed the petition. The order apparently incorporated a set of findings of fact that the trial court made after the trial in 2010 that, for some unexplained reason, were not made part of the record in Vilardi’s first appeal. Vilardi again appealed to the Third Department.
The Third Department’s decision earlier this month affirmed the trial court’s decision in Babbino’s favor, stating that deference must be given to the trial court’s credibility determinations and agreeing that Vilardi did not sustain his burden of proof to establish his 50% stock ownership.
The appellate court addressed the tax returns first by noting that “the information contained in corporate filings, such as tax returns, is not necessarily dispositive.” Then came the fatal blow to Vilardi’s second appeal:
"Here, the accountant who prepared the unsigned tax returns was a friend of petitioner and did not independently verify the information regarding ownership contained therein.
The implication is that Babbino was negligent at most in signing one or more of the contested tax returns, and in filing his own K-1s showing 50% ownership, and that the authenticity and source of the information in the tax return is the more important factor In light of the other, contradictory evidence in the case.
As the appellate court also noted, at the trial “the parties testified to two completely divergent explanations” of the various documents that they signed in 2007 evidencing, according to Vilardi, a “facade” to secure financing from lending institutions or, according to Babbino, an indebtedness owed by Vilardi to Babbino. While a contrary finding in Vilardi’s favor “would not have been unreasonable,” the court observed, the conflicting evidence and the deference due the trial court’s credibility assessments gave the appellate court no basis to reverse the trial court’s determination.
There are numerous cases unlike Sunburst, such as Matter of Capizola, 2 AD2d 843 (2d Dept 2003) and Matter of Pickwick Realty, Ltd., 246 AD2d 863 (3d Dept 1998), where the courts gave effect to share ownership as reflected in a corporation’s K-1s which, after all, are signed and filed with the IRS under pain of potential civil and criminal penalties for misinformation. Sunburst is a timely reminder, consistent with the confusing and muddled recordkeeping of many closely held businesses, that it is the totality of the evidence and, ultimately, the credibility of the testifying witnesses that determines the outcome.