Legal Update

June 2023

What happens when an owner pays him or herself a non-market rate of compensation? This month’s legal update presents, Mekhaya v. Eastland Food Corp., 287 A.3d 395; 2022 Md. App. LEXIS 938 (Md. Ct. App. December 22, 2022). In that case, an appellate court discusses what can happen when owners use their control prerogatives to pay owner employees more than a market rate for the services they provide to the organization.

Owner managed privately held businesses can sometimes play fast and loose with characterizations of employment compensation and equity holder dividends/distributions. Tax preparers will sometimes raise concerns that owner/employee compensation is too low (relative to market rates for the positions) as that can create a payroll tax underpayment issue. The valuation profession, on the other hand, typically makes a “normalization adjustment” for the difference, positive or negative, between the owner/employee’s compensation and market rates, and moves on. In Mekhaya v. Eastland Food Corp., 287 A.3d 395; 2022 Md. App. LEXIS 938 (Md. Ct. App. December 22, 2022), the appellate court discusses what can happen when owners use their control prerogatives to pay owner employees more than a market rate for the services they provide to the organization.[1]

Background

Defendant Eastland Food Corporation (“Eastland”) is a distributor of imported and domestic Asian food products headquartered in Howard County, Maryland. Eastland was founded in 1981 by Pricha Mekhayarajjananonth (“Pricha”). In 2000, the plaintiff, Edward Mekhaya (“Plaintiff”), one of Pricha’s sons, began working at Eastland. In December 2008, Plaintiff received 28% of Eastland’s stock. The remaining equity was owned by Plaintiff’s mother (35%), Plaintiff’s brother, Oscar, (28%) and Oscar’s children (collectively 9%). Eastland’s Board of Directors included Plaintiff, Oscar, their mother and a non-equity owner, Tisnai Thaitham.

Pricha, despite holding no equity, continued to run Eastland until the fall of 2017. For reasons not discussed in the court’s opinion, Pricha was terminated as president and a director, and Oscar was named president of the company. Plaintiff was the only director that opposed the move. At the time, Plaintiff was Eastland’s vice president of operations and earning approximately $400,000 per year. In the shareholders’ meeting in October 2018, Plaintiff was not re-elected to the Eastland board of directors, and a few days later, Plaintiff’s employment was terminated.

In 2021, Plaintiff sued Eastland and the remaining three directors, alleging, among other things, that the company had been paying shareholders salaries as if they were dividends. According to Plaintiff, at the October 2018 stockholders’ meeting, a suggestion was made to conduct a dividend study to consider the “advantages of moving to shareholders getting dividends with respect to ownership in lieu of their salaries being paid as if they were dividends.” Plaintiff further alleged that upon his removal from the board of directors and termination of his employment, that proposal was abandoned. Plaintiff contends that Eastland was “quite profitable” in the years following his termination, but the company would not pay dividends. Instead, according to Plaintiff, the company paid “excessively high salary and other compensation” to Oscar and his mother that “reduced” profits. Thus, according to Plaintiff, Eastland was paying “de facto” dividends to Oscar and his mother that were not in proportion to equity ownership.

Court Findings

Plaintiff’s complaint stated three counts: oppression of a minority shareholder, breach of fiduciary duty by the three directors, and unjust enrichment by Oscar and their mother. All three claims revolved around the alleged scheme to pay Eastland’s profits to shareholder employees as excess compensation and not paying profits to shareholders as distributions.

The defendants filed a joint motion to dismiss, arguing that Plaintiff had failed to state an oppression claim because the board had exercised its business judgment; both in terminating Plaintiff’s employment and electing to not declare dividends. They contended that absent an employment agreement or shareholders’ agreement, the board was free to act as it saw fit. With regard to the other counts, the defendants argued that Plaintiff’s “injury” was indistinct from the corporation and, therefore, such claims would belong to Eastland.

The trial court rejected Plaintiff’s contention that Eastland paid salaries as though they were dividends and, by terminating Plaintiff, the defendants had deprived him of his reasonable expectation of a share of the company’s profits. The trial court granted the defendants’ motion, holding that “dividends as salary” was a new concept and unsupported in case law. Regarding the second and third counts, the trial court found that the claims would be derivative and, since Plaintiff had not pleaded a derivative claim, they must be dismissed as well.

Following the entry of judgment, Plaintiff moved to amend his complaint to include, among other things, his salary history from 2006 through 2018, which showed a large jump in 2008 when he became a shareholder and how changes thereafter tracked Eastland’s profits. The trial court denied the motion to amend, and Plaintiff appealed.

The appellate court reversed. It found that term “oppression” under the Maryland Code describes “adverse treatment of minority shareholders in a closely held corporation by those who wield power within the company.”[2] This includes actions that “substantially defeats the reasonable expectations of a stockholder”[3] in a closely held corporation. Equity holders of closely held businesses generally consider themselves “as a co-owner of the business and wants the privileges and powers that go with ownership. Such privileges may include employment, a share of corporate earnings, and a role in the management of the company.”[4]

In closely held businesses, as opposed to publicly traded ones, there is a limited (and often nonexistent) market for the minority shareholder’s stake leaving them with “no effective means of salvaging the investment,”[5] when a majority owner (or faction) engages in conduct that defeats the minority shareholder’s reasonable expectations.

Contrary to the ruling of the trial court, the appellate court found that Plaintiff had properly alleged oppression by asserting that the salaries paid to his brother and his mother exceeded market rates and that the excess constituted a de facto dividend paid to the two employee shareholders in which he had not participated since his termination. The court recognized that, while the Maryland statutes did not expressly address the concept of “de facto dividends,” they also did not preclude their existence. The court looked to numerous authorities outside of Maryland that addressed the concept of a “constructive” or “disguised” dividend being paid as part of shareholder’s salary. These authorities included the Internal Revenue Code, which limits deductions for shareholder compensation to reasonable amounts paid for personal services rendered. Other sources included bankruptcy court decisions that addressed year-end “bonuses” that eliminated debtors’ profits, which were paid to shareholders in proportion to their stock ownership.

Another example the court considered was a ruling from the Alaska Supreme Court in a case where majority shareholders took profits from the company, at the expense of minority shareholders, through “directors’ fees.”

[R]egardless of how the corporation labels these expenditures, if they were not made for the reasonable value of services rendered to the corporation, some portion of these payments might be characterized as constructive dividends. … [S]uch transactions should be examined to determine whether they are in fact a distribution of dividends, and if so, the excluded shareholder must participate equally in the payments received by other shareholders.[6]

The court also cited similar rulings from Wisconsin, Michigan, Connecticut, Pennsylvania, New Jersey, and the Bankruptcy Court for the Middle District of Florida.

Conclusion

While discrepancies between a shareholder’s employment compensation and the market value of their services to the business seem readily resolved with a normalization adjustment, the existence of non-market-based compensation can create issues of “de facto” dividends which, in turn, can result in tax consequences and a potential finding of shareholder oppression.

[1] It is important to note that this appellate court ruling was on the trial court’s dismissal of the plaintiff’s complaint with prejudice. No discovery has taken place, and the plaintiff may ultimately be unable to prove the allegations in his complaint. However, at this stage, all of the plaintiff’s factual allegations are assumed to be true, and all inferences that may be drawn from those facts are viewed in the light most favorable to the plaintiff.

[2] 2022 Md. App. LEXIS 938 at **18, quoting Bontempo v. Lare, 444 Md. 344, 365, 119 A.3d 791 (2015).

[3] Ibid. citing Edenbaum v. Schwarcz-Osztreicherne, 165 Md. App. 233, 256, 885 A.2d 365 (2005) (quotation marks and citation omitted).

[4] Ibid. internal citations and quotation marks omitted.

[5] Ibid. at ** 19.

[6]   Id. at **29, quoting Alaska Plastics, Inc. v. Coppock, 621 P.2d 270 (Alaska 1980), internal punctuation and citations omitted.

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Michael J. Molder, JD, CPA, CFE, CVA, MAFF, applies 30 years of experience as a Certified Public Accountant and litigator to help investigate and analyze cases with complex financial and economic implications. He has acted as both counsel and accounting expert in pending and threatened litigation as well as participating in internal investigations of financial misconduct. As a litigator, Mr. Molder helped co-counsel understand complex financial and accounting issues in dozens of cases. In 2006, Mr. Molder returned to public accounting applying his unique skills to forensic engagements. He has also performed valuations of business interests in a wide variety of industries.

Mr. Molder has served as valuation expert for both plaintiffs and defendants in commercial litigation matters and owner and non-owner spouses in matrimonial dissolutions. He has participated in the valuations of businesses in a wide variety of industries, including: food service, wholesale and retail distribution, literary development and production, healthcare, manufacturing, and real estate development.

Mr. Molder has also investigated and valued damages in a wide variety of litigation contexts ranging from breach of contract claims to personal injury cases, and from employment disputes to civil fraud. He has consulted on many matters which have not involved the issuance of a report for litigation or resulted in deposition or trial testimony. Accordingly, the identity of these matters is protected by attorney client privilege.

Mr. Molder has also lectured widely on a variety of accounting and litigation related topics including business valuation, financial investigations in divorce proceedings, accountant ethics, financial statement manipulation and “earnings management.”

Mr. Molder can be contacted at (610) 208-3169 or by e-mail to Molder@lawandaccounting.com.