As business models evolve, owners often look at different ways to compensate key performers. Standard packages include base salary and bonuses, but many entrepreneurial businesses look to add company ownership to the compensation plan as a way to keep key performers invested in its success. The South Carolina Supreme Court recently addressed such a case, and its decision provides helpful do’s and don’ts. Read on to see how the court addressed the complicated situation.

Spawning Restaurants

Mark and Larkin Hammond built and operated several successful restaurants in their hometown of Lake Lure, North Carolina, and Greenville, South Carolina. They formed Lake Point Restaurants, Inc., a North Carolina S corporation, in 1998 and purchased a restaurant on the water in Lake Lure. They were the sole shareholders with equal ownership in the corporation. The restaurant purchase was financed through personal contributions by the Hammonds, owner financing, and third-party loans they personally guaranteed. The business operated as Larkin's on the Lake and remains a viable business today.

In 2000, the Hammonds hired Kyle Pertuis to manage the restaurant. As part of the compensation package, the parties agreed he would earn a salary plus bonuses based on profitability benchmarks, along with a 10% share in the business over the course of a five-year period at an agreed-upon vesting schedule. The schedule was designed to incentivize Pertuis to remain with the company for a period of time. Accordingly, by 2007, he owned a 10% share in Lake Point.

In 2001, the Hammonds formed Beachfront Foods, Inc., which also was a North Carolina S corporation, for the purpose of buying another restaurant on Lake Lure. As with Lake Point, they were the sole shareholders with equal ownership interests; the restaurant purchase was financed through their personal contributions, owner financing, and third-party loans they personally guaranteed; and the parties agreed on a five-year vesting schedule for Pertuis to attain a 10% ownership interest.

The second restaurant was renovated and rebranded as MaLarKie's, which represented a combination of the parties' first names—Mark Hammond, Larkin Hammond, and Kyle Pertuis. When Beachfront was formed, Pertuis' job title became "managing partner" since his duties included oversight of both restaurants. Along with the increase in job responsibilities, his compensation expanded. As with Lake Point, by 2007, he owned a 10% share in Beachfront.

For various reasons, MaLarKie's was not as successful as Larkin's on the Lake, and eventually Beachfront sold MaLarkie's and began operating a casual dining restaurant in nearby Columbus, North Carolina, called Larkin's Carolina Grill. It  was the least profitable of the three restaurants with a negative net income reported on its income tax returns each year from 2008–2012.

In 2005, the Hammonds formed Front Roe Restaurants, Inc., a South Carolina S corporation and purchased Rene's Steakhouse in Greenville. As with the other two corporations at the time of their formation, the Hammonds were sole shareholders with equal ownership interests, and the restaurant purchase was financed through their personal contributions and third-party loans they guaranteed. The business currently operates as Larkin's on the River and was the most profitable of the three corporations.

Several months after Front Roe was formed, Pertuis moved to Greenville and traveled to each restaurant weekly as part of his managerial duties. Although the parties agreed on a vesting schedule for him to acquire up to a 10% interest in Front Roe, by all accounts this agreement, unlike the others, was based on the restaurant's profitability benchmarks rather than length of service. Although none of the parties could produce a written vesting schedule, Mark Hammond testified the agreement was for Pertuis to receive a 1% interest in the year Front Roe first became profitable and an additional 9% once the company achieved a net operating profit of $500,000.

By 2007, Pertuis owned a 1% share of Front Roe. Both Hammonds and Pertuis agreed, however, that the corporation had never reached the $500,000 profit benchmark—a fact that was confirmed by the company’s tax returns. Pertuis never made any capital contributions or personal loans to the companies, either during or after his employment.

By late 2008 to early 2009, the parties began discussing different compensation packages to allow Pertuis to reach a 10% ownership interest in Front Roe. Despite multiple conversations between the parties and the involvement of attorneys and tax professionals, Pertuis eventually became frustrated with the perceived delay in the process of formalizing what he hoped would be a new agreement.

In early October 2009, Pertuis took some time off from the business to consider his options. In a lengthy e-mail to the Hammonds, he cited the sources of his discontent as, among other things, a feeling that his investment of time and energy into the business wasn’t paying off financially, industry burnout, and trouble achieving work-life balance. Ultimately, the parties split ways, although it's unclear whether the decision was driven by one side or mutual.

‘Squeezed Out’ of Business

Pertuis filed a lawsuit after unsuccessful attempts to negotiate the Hammonds' purchase of his' portions of the businesses, which was exacerbated by disagreements over the value of his shares and the extent to which he was entitled to certain business records. Essentially, Pertuis argued he was an oppressed minority shareholder who had been "squeezed out" of the business in bad faith and that he was therefore entitled to a forced buyout of his shares, including a 10% ownership share in Front Roe.

After a bench trial, the trial court found the three corporate entities—Lake Point, Beachfront, and Front Roe—should be amalgamated into a single business enterprise located in and operating out of Greenville. The court further found Pertuis was an oppressed minority shareholder and awarded him a 7.2% ownership interest in Front Roe as well as $99,117 in unpaid corporate distributions from Lake Point and Front Roe. The court valued each of the three corporations and ordered a buyout of Pertuis' shares by the Hammonds. The court of appeals affirmed. This supreme court issued a writ of certiorari—an order to the lower court to turn over its record so that the higher court may review it.

Supreme Court’s Analysis

The Hammonds argued the appeals court erred in upholding the trial court's finding that the three corporations operated as a single business enterprise with its location in Greenville. They also contended the appeals court erred in (1) affirming the trial court's decision to award a 7.2% ownership interest in Front Roe and $99,117 in shareholder distributions to Pertuis, (2) valuing Beachfront at $0 rather than assigning a negative value to it, and (3) finding Pertuis was an oppressed minority shareholder.

Amalgamation of three corporate entities. Addressing the first issue raised by the Hammonds, the supreme court agreed the lower courts erred in amalgamating three corporations into one South Carolina entity. Dealing with two North Carolina corporations and one South Carolina corporation, the supreme court found that South Carolina law should govern its evaluation of the amalgamation claim. After all, Front Roe was a South Carolina corporation, much of the conduct at issue occurred in the state, and Pertuis, the minority shareholder, is a state resident.

Next, the supreme court had to decide what to do when multiple corporations have unified their operations and resources to achieve a common business purpose. If adhering to the fiction of separate corporate identities would defeat justice, should South Carolina refuse to recognize their separateness and, to the extent that the specific fact situation would warrant, instead regard them as a single enterprise?

The supreme court announced it was formally recognizing the single business enterprise theory. The court acknowledged that corporations are often formed to shield shareholders from individual liability but that there is nothing remotely nefarious in doing so. The theory requires showing more than just that the various entities' operations are intertwined. Combining multiple corporate entities into a single business enterprise requires further evidence of bad faith, abuse, fraud, wrongdoing, or injustice resulting from the blurring of the entities' legal distinctions. As with other methods of piercing the corporate form that have previously been recognized in South Carolina, equitable principles govern the application of the single business enterprise remedy, and the doctrine shouldn’t be applied without substantial reflection.

Supreme court’s decision. Applying those standards, the supreme court found the trial court's analysis not only failed to assign the burden of proof to Pertuis, as the party seeking amalgamation, but also overlooked the companies' status as S corporations, which are legally permitted to disregard the very corporate formalities the lower court had identified as lacking. The supreme court held that it was an error to consider the Hammonds’ three distinct corporations as a single business enterprise.

Properly viewing the corporations as the three distinct entities they are, the supreme court reversed the appeals court’s decision and tossed out the trial court's rulings as they related to Beachfront and Lake Point. The supreme court, however,  upheld the finding that Pertuis is entitled to unpaid distributions from Front Roe, but modified the award to $14,142, which removed the funds attributable to the North Carolina corporations.

The Hammonds further contended the court of appeals erred in upholding the trial court's award of a 7.2% ownership interest in Front Roe to Pertuis. The supreme court again agreed and reversed the lower court.

The record reflected (and it was undisputed) that Pertuis never received any share certificates for his ownership interest in Front Roe. The corporation's tax returns from 2005 through 2012 indicated that, from 2007 forward, his ownership interest in Front Roe was 1%. In addition, his claim to a 10% ownership interest in the restaurant was tied to profitability benchmarks. His reliance on e-mail exchanges with Mark Hammond was unavailing.

The evidence clearly showed that Pertuis' ownership share in Front Roe was 1%. The trial court determined the restaurant’s fair-market value was $1,376,000. Accordingly, the cost of purchasing his shares was $13,760.

Lessons for Employers

Compensation and ownership issues need to be well documented. Handshake and e-mail-exchange approaches often result in misunderstandings and can lead to contentious and expensive litigation. If you decide to offer compensation beyond a base salary, the court’s decision suggests three things:

• Know what type of business entity you have and the laws in the states where you’ve set up both your headquarters and other operations.
• Set forth the criteria that will apply to the “other” compensation (e.g., bonuses or ownership rights).
• Specify the benchmarks that will need to be met to reach the eligibility standards for the compensation, and secure the appropriate signatures.

Rewarding people who contribute to your business success can be beneficial, but spell out in detail how and when the benefits will be delivered.

Richard J. Morgan, an editor of South Carolina Employment Law Letter, may be reached at rmorgan@mcnair.net.