Jorgensen v. Water Works, Inc.

• Decision Date: 24 May 2001
• Docket Number: No. 00-1930.,00-1930.
• Citation: 630 N.W.2d 230,246 Wis.2d 614,2001 WI App 135
• Parties: Duane S. JORGENSEN and Sharon A. Jorgensen, Plaintiffs-Appellants, v. WATER WORKS, INC., Defendant, James S. BARBER, Doreen A. Barber, Gary W. Tesch, and Mary Tesch, Defendants-Respondents.
• Court: Wisconsin Court of Appeals

246 Wis.2d 614

2001 WI App 135

630 N.W.2d 230

Duane S. JORGENSEN and Sharon A. Jorgensen, Plaintiffs-Appellants, v.WATER WORKS, INC., Defendant,James S. BARBER, Doreen A. Barber, Gary W. Tesch, and Mary Tesch, Defendants-Respondents.¹

No. 00-1930.

Court of Appeals of Wisconsin.

Submitted on briefs February 12, 2001.

Decided May 24, 2001.

On behalf of the plaintiffs-appellants, the cause was submitted on the briefs of Jerry W. Slater of Kelley, Weber, Pietz & Slater, S.C. of Wausau.

On behalf of the defendants-respondents, the cause was submitted on the brief of Gary L. Dreier of First Law Group S.C. of Stevens Point.

Before Vergeront, Roggensack and Lundsten, JJ.

¶ 1.ROGGENSACK, J.

Because we conclude, based on the facts found by the circuit court, that the individual defendants breached their fiduciary duties as directors of Water Works, Inc. by violating the shareholder-rights of Duane and Sharon Jorgensen, which caused an injury that was primarily personal to them, we reverse and remand for further proceedings consistent with this opinion.

BACKGROUND

¶ 2.This is the second time this case has been before us.²The plaintiffs, Duane and Sharon Jorgensen, are shareholders in Water Works, a corporation that owns and operates a car washing facility in Wisconsin Rapids.The individual defendants, James Barber, Doreen Barber, Gary Tesch and Mary Tesch, are the remaining shareholders in the corporation.They are also the directors and officers of Water Works.Since its inception in 1988, Water Works has elected to be taxed under subchapter S of the Internal Revenue Code.³

¶ 3.Initially, the business venture got off to a good start.Each shareholder was issued an equal number of shares in the corporation, and each was a director and an officer, with Duane being elected president.Each received regular payments from Water Works.Those payments increased in size and frequency as Water Works became profitable.Each year, Water Works filed a federal tax return using IRS form 1120S, which passed through all corporate income and losses to the six shareholders in equal amounts.

¶ 4.Disagreements among the shareholders arose in 1996, causing Duane to resign and Sharon to be removed as officers and directors.The weekly payments they had been receiving from Water Works also ceased, but Doreen, James, Gary and Mary continued to receive their regular payments.Duane and Sharon then sued the other shareholders alleging they had breached the fiduciary duty which they, as directors, owed to the Jorgensens as Water Works shareholders.The Jorgensens also alleged a derivative claim for unpaid dividends and a claim for judicial dissolution based on what they contended was oppressive conduct by the individual defendants, under WIS. STAT. § 180.1430(2)(b)(1999-2000).⁴

¶ 5.The circuit court granted summary judgment dismissing all claims.We reversed in part, reinstating the Jorgensens' individual claims for breach of fiduciary duty and the claim for judicial dissolution because we concluded there were genuine issues of material fact surrounding those claims.

¶ 6.When the matter was again before the circuit court, it held a two-day trial and found that the defendants had not proved that the fees they were paying themselves from Water Works were reasonable for the services they had rendered to the corporation.The court also found that it was "obvious that the salaries and the payment of salaries is related to profits [of the corporation]."The court found that because there was "no differentiation between directors' salaries — or, at least, there hasn't been since 1996 — suggests that salaries aren't being paid on the basis of work done as compensation for work done."The court further found that there was no demonstration that Sharon's removal from the board of directors was based on her conduct, and that her dismissal meant a loss of the Water Works' fees the Jorgensens had previously received.Based on those findings, the circuit court concluded that "your conduct was in breach of your fiduciary duty."

¶ 7.However, instead of then determining what damages the Jorgensens had suffered, the circuit court reasoned that if smaller payments were made to the four defendant-directors, there would be more money to pay off the loans which encumbered the corporation and that, in turn, might cause the lenders to permit the payment of dividends to all shareholders as a regular and routine matter.Because it believed the Jorgensens had no individual right to require the corporation to pay dividends and that the cash flow payments to the defendants could affect the future payment of dividends, the court concluded that the challenge to those payments had to be brought as a derivative action.The circuit court also concluded that the majority shareholders' voting Sharon off the board was not oppressive conduct as that term is used in WIS. STAT. § 180.1430(2)(b).The circuit court's decision regarding oppression has not been appealed, but Duane and Sharon do appeal the dismissal of their individual claims for breach of fiduciary duty.

DISCUSSION

Standard of Review.

[1, 2]

¶ 8.Whether a corporate director has breached his or her duty to deal fairly with individual shareholders is a mixed question of fact and law.SeeReget v. Paige,2001 WI App 73, ¶ 12, 242 Wis. 2d 278, 288-89, 626 N.W.2d 302, 308.Whether certain events occurred are questions of historic fact to be determined by the circuit court.We will not reverse those determinations unless they are clearly erroneous.Id.at ¶ 11;WIS. STAT. § 805.17.However, whether the facts as found constitute a breach of a director's duty to individual shareholders is a question of law.SeeReget,2000 WI App 73 at ¶¶ 11-12.Breach of Fiduciary Duty.

¶ 9.On appeal, Duane and Sharon claim that the circuit court erred in concluding that their claim for improper distributions from Water Works must be brought as a derivative action rather than as an individual claim.They seek reversal and remand for further proceedings.

[3-6]

¶ 10.A corporation's directors owe individual shareholders a fiduciary duty to act in good faith and to deal fairly with them.Rose v. Schantz,56 Wis. 2d 222, 228, 201 N.W.2d 593, 597(1972);Grognet v. Fox Valley Trucking Serv.,45 Wis. 2d 235, 242, 172 N.W.2d 812, 816(1969).That duty requires that directors not "use their position of trust to further their private interests."Rose,56 Wis. 2d at 228, 301 N.W.2d at 597.Whether a claim must be brought derivatively or may be brought individually depends upon whether the injury alleged is primarily to the complaining shareholder or primarily to the corporation.Jorgensen v. Water Works, Inc.,218 Wis. 2d 761, 776-77, 582 N.W.2d 98, 104(Ct. App.1998).As the supreme court explained in Rose,"[W]here some individual right of a stockholder is being impaired by the improper acts of a director, the stockholder can bring a direct suit on his own behalf because it is his individual right that is being violated."Rose,56 Wis. 2d at 228-29, 301 N.W.2d at 597.

¶ 11.As we evaluate whether the Water Works' payments to the defendants after discontinuing payments to the Jorgensens are primarily injuries to Duane and Sharon personally, we note that Water Works is a subchapter S corporation.Subchapter S of the Internal Revenue Code,26 U.S.C. §§ 1361-1379, was enacted in 1958 to assist small businesses in adopting the corporate form of business by lessening the tax burdens on them.Bufferd v. Commissioner,506 U.S. 523, 524-25(1993).A subchapter S corporation uses a pass-through taxation system where, generally,⁵ corporate income, losses, deductions and credits are attributed to the individual shareholders on a pro rata basis, similar to the tax treatment of a partnership.⁶Gitlitz v. Commissioner of Internal Revenue,531 U.S. 206, 209, 121 S. Ct. 701, 704(2001)(citingBufferd,506 U.S. at 525).Each shareholder is required to report, as taxable income, his or her share of the corporation's pass-through income, even if he or she does not receive corporate payments, subject to a limitation on losses in excess of a shareholder's basis.See26 U.S.C. § 1366 (a)(1)(A)and§ 1366 (d);Gitlitz,121 S. Ct. at 704.Generally, a subchapter S corporation does not pay dividends from corporate profits, but rather, passes-through its profits to the shareholders on a pro rata basis.Id.The amount of income available for pass-through is affected by the deductions taken from revenues for compensation and fees to officers and directors prior to calculating the pass-through income.See IRS form 1120S.

¶ 12.The record reflects that Water Works filed IRS forms 1120S as a subchapter S corporation for all the years in question.In 1997 and again in 1998, Water Works paid the four defendants $16,900 each as "officers' compensation."The circuit court found that these payments were not based on work performed for the corporation but instead were distributions related to profits of Water Works.⁷Neither Duane nor Sharon received officer's or director's compensation or salaries⁸ of any type in 1997 and 1998, although both had received them annually before being removed as officers and directors.

¶ 13.In 1997, the first year in which Duane and Sharon received no cash flow payments from Water Works, the corporation reported pass-through income of $37,593, causing pro rata pass-through income for each shareholder of $6,265.50.In 1998, Water Works reported $25,452 of pass-through income, causing reportable income of $4,242 for each shareholder.It is undisputed that, while Duane and Sharon were required to report this pass-through income on their tax returns, no pass-through income was actually distributed to any shareholder.⁹¶ 14.The circuit court also found that when the defendants stopped paying officer's and director's fees to Duane and Sharon and continued to pay themselves fees, "then you've basically taken...