Shareholders Can’t Take Profit Distributions At Will

You are being judicious, prudent, and disciplined and are plowing your corporation’s earnings back into your corporation.

You are reinvesting in your business because that is how you grow your business.

But your business is doing well and you are in business to reap the benefits of your hard work and diligence.

As a shareholder, and more so as the controlling shareholder, you might believe you are entitled to take the occasional distribution of profits from the corporation.  Why would anyone care if you were to take a distribution to pay yourself?

You are generally correct that you, the shareholder, have a right to take a distribution of profits to pay yourself.  But like most legal rights, there are exceptions, conditions, and limits to be aware of.

For example, under California law a corporation cannot make any distributions to its shareholders without approval by the board of directors.

You might be the sole shareholder and lone member of the board so it may seem that there should be no question about approving a distribution.  It is true that you could readily approve a distribution by signing a unanimous written consent to that effect.

But there is a condition that must be first satisfied by the board of directors.  The board must determine in good faith one of two things.

Will the corporation have sufficient retained earnings before the distribution to the shareholder(s)?

Or, will the corporation’s assets be of a sufficient value after the planned distribution?

If the board determines that the corporation’s retained earnings will be equal to or greater than the amount of the distribution plus overdue dividends owed to preferred shareholders (if any), the distribution is allowed.

Or the board can determine that the corporation’s assets, after the distribution, will be equal to or greater than the corporation’s total liabilities plus the amount to pay preferential rights of shareholders (if any).

If either condition is satisfied in the board’s good faith discretion, the distribution of profits can be approved.

Preferential rights are rights that are paid to some shareholders before other shareholders who do not have such rights.  Not all corporations have these but if you have investors in your corporation, there may be some shareholders with these rights and they are paid first before the common shareholders or there must be enough value, earnings, etc. to be able to pay them.

The board of directors can rely on financial statements that are prepared using reasonable accounting principles in making its determination.

The board can also use a fair valuation or any other method that is reasonable.

Also, the articles, bylaws and any other agreements between the shareholders must be reviewed because those documents might contain additional limits or restrictions on distributions of profits to shareholders.

There is a further limit on distributions to note here.  If the corporation will not be able meet its liabilities that are not provided for, the distribution is not allowed.  In other words, your corporation must be able to continue to pay its bills after the distribution of profits.

Once the board has made these determinations, in good faith, distributions can generally be made to the shareholders.

References: California Corporations Code sections 500 and 501.

This discussion is not legal advice, a solicitation of you as a client, nor the engaging in the practice of law in any jurisdiction.

This discussion is merely for information/education and should not be relied upon for legal advice by anyone because the facts discussed may be different from your own situation.  If you need legal advice, consult a qualified attorney.

For more information please visit my website at www.palacioslawoffice.com.

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About Elio Palacios, Jr.

Attorney Elio Palacios, Jr., represents individuals, corporations, entrepreneurs, small businesses, startups and early stage businesses, physicians, dentists, and healthcare businesses in corporate, business and commercial transactions and litigation. He also counsels employers and individuals on visa, immigration and naturalization matters. Visit www.PalaciosLawOffice.com to learn more.
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