There are many mechanisms that family-owned businesses can use to help ensure that owner voting rights are exercised only by mature, responsible family members who have demonstrated a commitment to the family business or have otherwise “earned” the right to vote. One such mechanism is the use of “tenure voting” rights, which allow a shareholder to vote their shares only after they have owned stock for a specified period of time, such as 5 or 10 years.
First, what do shareholders ordinarily have the right to vote on?
Under the default rules of the corporation statutes of most states, shareholders have the right to vote on a limited set of important subjects. Usually, the rules provide for the shareholders to meet once a year to elect directors. In addition, shareholders may be called upon to vote, at the annual meeting or at a special meeting, on changes to the company’s governing documents (such as articles of incorporation or bylaws) or on existential transactions such as selling, merging, or dissolving the company.
The company’s governing documents, however, can broaden the set of subjects that require a shareholder vote, such as admitting new shareholders, issuing new shares of stock, paying dividends, or taking on substantial new debt.
Although shareholders vote on important matters, shareholders generally do not have a fiduciary duty to exercise their votes in a prudent manner or in the best interests of the company or the other shareholders, except perhaps when they hold a majority of the votes. For this reason, many family businesses try to ensure that voting rights do not fall into the hands of a person who cannot be trusted to exercise those rights wisely and in good faith.
How does tenure voting work?
Under the default rules of the corporation statutes of most states, each share of a corporation’s stock is entitled one vote on matters that require a vote of shareholders, but that rule can be changed if expressly permitted in the corporation’s articles of incorporation (a/k/a charter). In the case of tenure voting, the corporation’s articles of incorporation would provide that a shareholder may vote their shares of stock only after they have owned the shares for a specific period of months or years. Under such a system, shareholder meeting quorums and voting tallies would be determined without regard to shares held by shareholders who were not yet entitled to vote.
In a family business, tenure voting would require new shareholders to show their commitment to owning shares over the long term before they were allowed to affect the company’s governance. Share voting rights, in such cases, would less likely be exercised in a way that would lead to short term pay offs, such as payment of excessive dividends or liquidation of company assets, at the expense of long term objectives and preservation of family legacy. Tenure voting also would naturally require a shareholder to attain a particular age before they could vote their shares.
Although there are other ways by which a family business could control or limit shareholder voting rights, tenure voting has the advantage of applying to every shareholder, without singling out particular family members or family branches.
Would tenure voting work for subchapter S corporations or LLCs?
Tenure voting should be permitted for a family business that is taxed as a subchapter S corporation. Generally, an S corporation is not allowed to have more than one class of stock, but the applicable Treasury Regulations provide an express exception for voting and nonvoting stock. “[I]f all shares of stock of an S corporation have identical rights to distribution and liquidation proceeds, the corporation may have voting and nonvoting common stock, a class of stock that may vote only on certain issues, irrevocable proxy agreements, or groups of shares that differ with respect to rights to elect members of the board of directors.” Treas. Regs. § 1.1361-1(l)(1) (emphasis added). In such cases, the corporation must be careful that the buy-sell provisions in its governing documents do not have different redemption prices or otherwise differentiate the value of voting versus nonvoting shares.
Similarly, tenure voting should be permitted for a family business that is organized as a limited liability company (“LLC”). In fact, the rules for governance of LLCs are much more flexible than those for corporations. The specific application of the tenure voting concept to an LLC, however, will depend on whether the LLC is member managed or manager managed.
How does tenure voting affect gift taxes and estate taxes?
For gift tax and estate tax purposes, shares of stock with tenure voting rights should be valued without respect to the possibility that the successor owner might not be able to vote the shares for a period of time. The shareholder’s estate planner, however, should consider whether tenure voting rights might have unintended consequences for gift taxes or estate taxes in a particular circumstance.
For example, IRC § 2704 contains special gift tax and estate tax valuation rules for stock with lapsing voting rights. Also, IRC § 2036, contains special rules that would impose estate taxes on stock that the decedent gifted during lifetime if the decedent retained the voting rights. (It is conceivable that the § 2036 rules could be implicated if the decedent made gifts of stock but retained voting control of a corporation only because of the operation of tenure voting rights.)
Conclusion.
Tenure voting is one of the many ways that family-owned businesses can tailor their corporate governance to be best suited to the circumstances and objectives of the business and the family.
Gregory Monday
gmonday@reinhartlaw.com
6/8/2020