In People v. Roscoe (2008) 169 Cal. App. 4th 829, two individuals (John F. Roscoe and Ned F. Roscoe) were officers, directors, and shareholders of a family company for an underground storage tank that leaked over 3,000 gallons of gasoline into the ground. The Sacramento County District Attorney filed a civil lawsuit against the company and the two Roscoes (among others) for violating laws governing underground storage of hazardous substances. The trial court found that the two officers (the Roscoes) could have prevented or remedied promptly the violations but that they did not “exercise their responsibilities and power to use all objectively possible means to discover, prevent, and remedy any and all violations.” Had a timely cleanup operation occurred, the court found, the cost likely would have been approximately $400,000 instead of the $ 1.5 million already paid by the State of California Underground Storage Cleanup Fund.

The trial court used the responsible corporate officer doctrine to impose $2,493,250 in monetary civil penalties on the two officers personally. The family company that “owned and operated” the tank was also held jointly and severally liable.

The responsible corporate officer doctrine was developed by the U.S. Supreme Court in criminal cases to hold corporate officers in responsible positions of authority personally
liable for violating strict liability statutes protecting the public welfare. It is a common law theory of liability separate from piercing the corporate veil or imposing personal liability for direct participation in tortious conduct. The decisions of the U.S. Supreme Court in construing federal legislation are not binding on the state courts in construing state legislation, but the court of appeal in this case analyzed the pertinent statute and found that it was consistent with the wording and intent of the statute to hold corporate officers personally liable for a corporation’s violation of the statute. The court rejected the argument that a distinction should be made between civil liability and criminal liability.

Lessons Learned

A corporation or limited liability company (LLC) is a limited liability entity, but that does not mean that the officers or managers of such an entity are immune from liability for not complying with regulatory regimes that apply to the entities that they manage. Although the alter ego doctrine (also known as piercing the corporate veil) did not apply here, that did not save the officers. There are a number of theories under which officers or shareholders of a corporation, or managers or members of an LLC, may be held liable for the actions or omissions of the entity. Therefore advice from knowledgeable counsel and careful attention to that advice can make the difference between being personally liable for the corporation’s or LLC’s obligations or not.

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When a California corporation dissolves, it continues to exist for the purpose of defending claims against it (and prosecuting claims in its name), though a claim by a creditor against a shareholder to recover assets distributed in the distribution must be filed within four years of the date of dissolution, or the claim will be barred. Delaware has a similar rule, but the corporation must be sued within three years of the date of dissolution.  What happens when a lawsuit is filed against a dissolved Delaware corporation in California more than three years after the corporation is dissolved?

In Greb v. Diamond International Corporation (2010) 184 Cal. App. 4th 15, this question arose. The plaintiff argued that the California Corporations Code should apply. California Corp Corporations section 2010 provides that “A corporation which is dissolved nevertheless continues to exist for the purpose of winding up its affairs, prosecuting and defending actions by or against it… .” This section has no time limit. Since the lawsuit was filed within four years of the date of dissolution, a successful claim against the corporation would allow the plaintiffs to pursue shareholders for assets distributed in the dissolution.

California, like most states, has routinely held the law of the state of incorporation determines the consequence of a corporate dissolution. California Corporations Code section 102 provides that, with certain exceptions not applicable here, the provisions of the Corporations Code apply to domestic corporations only, and that application to other corporations is permitted only “to the extent expressly included in a particular provision of this division.” Unlike some other sections, Corporations Code section 2010 makes no mention of foreign corporations.

Accordingly, the court held that the Delaware time limit of three years applied, and the claim of the plaintiffs was barred by the passage of time.

Lessons Learned

When the business of a California corporation is wound up, the shareholders should formally dissolve the corporation. A California corporation must pay a minimum franchise tax of $800 every year whether it conducts business or not.  Only dissolution will stop the accrual of this tax. In an effort to save on legal fees, many closely-held corporations with wound up businesses are simply abandoned, rather than formally dissolved. After a number of years of not paying the annual tax, the corporation is suspended by the state. Some incorrectly view this as equivalent to dissolution. This can be a costly  mistake.

Sometimes a claim needs to be brought in the name of the corporation, but a suspended corporation can not maintain a lawsuit. That’s one of the consequences the legislature has imposed on a corporation for being suspended. To bring a claim, a suspended corporation must be revived. And to do that, all the back taxes along with penalties and interest must  be paid to obtain a certificate of revivor from the Franchise Tax Board. If the suspended corporation had been  properly dissolved, back taxes would not have accrued, and the shareholders could bring the action in the name of the corporation without having to obtain a certificate of revivor.

More importantly, not dissolving formally means that the four-year period for claims against shareholders of a dissolved corporation never starts to run. Claims against shareholders of a suspended corporation can be brought until barred by some other statue of limitations.

Finally, observing corporate formalities, which includes dissolving a corporation formally, is a factor courts use in determining whether to pierce the corporate veil.

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In Ahcom, Ltd. v. Smeding, 623 F.3d 1248 (9^th Cir. 2010), the U.S. Court of Appeals for the Ninth Circuit decided the question whether a creditor of a corporation that is in bankruptcy has standing to pursue a claim against the corporation’s shareholders on an alter ego theory or whether alter ego claims of creditors belong solely to the corporation’s bankruptcy trustee.

The plaintiff, Ahcom, Ltd., a United Kingdom-based corporation, entered into a contract to buy almonds from a California corporation. The California corporation allegedly failed to deliver the contracted-for almonds. Pursuant to a clause in the contract, Ahcom brought, and prevailed in, a foreign arbitration proceeding against the California corporation.

Ahcom then sued in California state court to collect its arbitration award, but it did not sue the corporation itself, which had petitioned for bankruptcy shortly after losing the arbitration. Instead, Ahcom sued the corporation’s shareholders, the Smedings, alleging an alter ego theory and seeking to pierce the corporate veil to hold the Smedings liable for a claim related to the foreign arbitration award and for a breach of contract claim. Aside from the alter ego theory, Ahcom had no claim against the Smedings.

The Smedings removed the matter to federal court and attacked Ahcom’s alter ego theory. They argued that Ahcom was asserting a claim of harm not just to Ahcom alone but to all creditors and thus that claim was exclusively the property of the trustee in bankruptcy. The district court agreed and dismissed Ahcom’s complaint without leave to amend. The court of appeals reversed.

The court of appeals noted that a Chapter 11 bankruptcy trustee stands in the shoes of a debtor corporation and has standing to bring any suit that the debtor corporation could have brought had it not petitioned for bankruptcy. When the trustee has standing to assert a debtor’s claim, that standing is exclusive and divests all creditors of the power to bring the claim. But that standing is limited. The trustee may assert only claims belonging to the debtor corporation and has no standing generally to sue third parties on behalf of the estate’s creditors. Although federal bankruptcy law governs the bankruptcy proceeding, state law determines whether a claim belongs to the trustee or to the creditor, and, in this case, the parties agreed that California law applied.

The court of appeals noted case law to the effect that there is no such thing as a substantive alter ego claim, that an alter ego claim is procedural in nature. In Mesler v. Bragg Management Co., (1985) 39 Cal. 3d 290, which the court cited, the California Supreme Court was in unanimous agreement that a finding of alter ego for the purpose of a particular action does not mean that the corporate veil will be pierced as to all suits or creditors for all purposes.

Notwithstanding Mesler and other precedent, the Smedings argued that Stodd v. Goldberger, (1977) 73 Cal. App. 3d 827, created a “general alter ego claim” that a trustee in bankruptcy can assert on behalf of all creditors, relying on Bank of Maui v. Estate Analysis, Inc., 904 F.2d 470 (9th Cir. 1990), a bankruptcy appellate panel decision and on a bankruptcy court opinion in Davey Roofing, 167 B.R. 604, 608 (Bankr. C.D. Cal. 1994). Those cases had relied on Stodd, but the court of appeals ruled that they had misread Stodd.

The court of appeals read Stodd as applying only where the corporation suffered a distinct injury to its own assets, such as through fraudulent conveyance, conversion, or theft by a shareholder, not that a trustee in bankruptcy would have standing to assert a free-standing general alter ego claim that would require a shareholder to be liable for all of a company’s debts. The court of appeals concluded that California law does not recognize a claim that would allow a corporation and its shareholders to be treated as alter egos for purposes of all the corporation’s debts and that the trustee in bankruptcy could not bring such a claim against the Smedings under California law. As a result, the creditor was not precluded by the bankruptcy of the corporation from pursuing its alter ego claim against the Smedings.

Comment

The holding in Ahcom will eliminate a theory that had the potential (realized in some cases) for much mischief. There were cases in which a shareholder of a bankrupt corporation purchased the alter ego claim from the bankruptcy trustee for a fraction of the face amount of the unsecured claims but for more than any one individual creditor was willing to pay. As a result, creditors with just claims were deprived of the ability to pursue their claims in court and often received nothing or next to nothing from the bankruptcy estate. Treating the alter ego claim of creditors against shareholders as a corporate asset belonging to the estate and allowing a shareholder to purchase the claim allowed shareholders of insolvent corporations to perpetuate the injustice that the alter ego theory seeks to prevent.

On the other hand, creditors of insolvent corporations may find this decision unwelcome if they have claims that are too small to make them economically worthwhile to pursue individually but which would be valuable to the trustee in the aggregate.

Ultimately, however, the correctness of the decision must be judged not by who stands to benefit but by its consistency with the body of law of which it is a part, and by this standard, the court’s holding in Ahcom is correct.

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Knowingly dealing with a thinly capitalized corporation and not asking for a guaranty will make it tough to pierce the corporate veil. This is illustrated by the case of Fusion Capital Fund II, LLC, v. Ham, 614 F.3d 698 (7th Cir. 2010), a case decided under Nevada law.

Millenium Holding Group, Inc., a Nevada corporation, had shares that were publicly traded over the counter. Millenium had few assets and no ongoing business and was insolvent.

Millenium entered into a contract with Fusion Capital Fund II under which Fusion promised to invest $15 million, subject to certain conditions. According to Fusion, the conditions were not satisfied, and Fusion wrote to Millenium that the money would not be forthcoming. Millenium then sued Fusion in Nevada for tortious interference with a merger agreement that was dependent on Millenium receiving the $15 million. Millenium lost. The contract between the parties had an attorney’s fee clause, and upon prevailing in the litigation, Fusion was awarded its attorney’s fees. The hunter became the hunted when Fusion turned around and sued Millenium in Illinois to recover its for attorney’s fees.

Of course, a claim against Millenium wasn’t worth the paper it would be written on, and Fusion needed a deep pocket (or at least a pocket) to tap into. Not surprisingly, it chose the two owners who were majority shareholders and the sole board members. Millenium owed Fusion about $1.2 million for legal fees, and since Millenium was judgment-proof (that is, broke and unable to pay a judgment), the district court, applying Nevada law, found that the majority shareholders were personally responsible for Millenium’s obligation to Fusion for legal fees.

Unlike California, Nevada has a statute on the subject of alter ego. It provides that:

1.   Except as otherwise provided by specific statute, no stockholder, director or officer of a corporation is individually liable for a debt or liability of the corporation, unless the stockholder, director or officer acts as the alter ego of the corporation.

2.   A stockholder, director or officer acts as the alter ego of a corporation if:

(a)   The corporation is influenced and governed by the stockholder, director or officer;

(b)   There is such unity of interest and ownership that the corporation and the stockholder, director or officer are inseparable from each other; and

(c)   Adherence to the corporate fiction of a separate entity would sanction fraud or promote a manifest injustice.

Although California has no such statute, California Law is much the same as principles outlined in Nevada’s statute.

On appeal, the appellate court  reversed  the district court, saying that the evidence supported a finding of the first two elements ((a) and (b) above) but not as to third element ((c) above). As the court put it, there wasn’t any fraud because Fusion knew “that Millenium [was] a husk without any corn inside.”

The court held that this knowledge made it hard to see how limiting the shareholders’ liability would promote an “injustice.” Fusion was not deceived in any way. As far as the court was concerned, the “injustice” component comes to the fore when a creditor’s claim is based on tort law because victims rarely understand in advance that they are dealing with shell corporations (if indeed they understand before the injury that they are dealing with the corporation at all). It may be important for some contract claims too, if the corporation leads the other party to think that it is normally capitalized and will be able to satisfy its obligations. But Fusion not only understood that Millenium was a shell but it also understood that Millenium’s insolvency was the dominant feature in the deal’s structure.

The court stated that when Millenium signed a contract promising to reimburse Fusion’s legal expenses if litigation ensued, Fusion knew beyond doubt that Millenium would be unable to keep that promise (unless a merger that was a condition in fact closed).

The court observed that someone who wants to protect himself against the possibility that a thinly capitalized corporation will be unable to pay its debts asks the owners for a guaranty. It is feckless to do business with a corporation such as Millenium without one. Yet Fusion not only did not get a guaranty but also did not even ask for one. There are a number of court decisions which hold that people who knowingly deal with a corporation without getting a guaranty can’t turn to shareholders on an alter-ego or veil-piercing theory.

The wrinkle in this case is that Fusion argued a different kind of “injustice”:  Millenium took the offensive in the Nevada suit! If it had prevailed, the shareholders would have pocketed 100% of the money; when Millenium lost, the shareholders argued that they owed nothing. But the court noted that this asymmetry is common in corporate transactions. If Fusion wanted to be protected from this asymmetry, it should have negotiated for a guaranty and refused to deal if the shareholders would not give one.

Lessons Learned

This decision doesn’t break any new ground, and the result is simple common sense to most people experienced in business. Parties should get a guaranty (if they can) before entering into a contract with a corporation that is not financially strong.

Parties are often willing, however, to take the risk of the corporation going under.  What they may not realize, however, is that the lack of a guaranty may turn an attorney’s fee clause in a contract with a financially weak corporation into a one-sided proposition (notwithstanding Civil Code §1717), and the insolvent corporation may take the offensive. In that event, it’s “heads I win, tails you lose” for the financially  stronger party.

An attorney’s fee clause is standard in many business contracts, and many lawyers will include one without thinking about the consequences. But exceedingly careful counsel will think about what disputes are likely to arise from the contract and who stands to benefit from an attorney’s fee clause before including one in the agreement.

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Shaoxing County Huayue Import & Export v. Bhaumik

In Shaoxing County Huayue Import & Export v. Bhaumik (2011) 191Cal.App. 4th 1189, a creditor of a bankrupt corporation sued in state court to recover payment from an individual based on an alter ego theory of liability. The individual argued that the alter ego claim belonged to the bankruptcy estate because it alleged general injuries to the corporation that could establish a basis of liability for all corporate debts and therefore the claim did not belong to the creditor. The court disagreed, holding that the creditor’s claim against the individual as an alter ego for the bankrupt corporation was not the property of the bankruptcy estate and therefore could be pursued by the creditor.

The creditor was a vendor of goods who was owed over $291,000. The defendant was an individual who was the general manager. Whether he was a  shareholder is not clear since the corporation may never have issued stock, but the court sometimes . The defendant appeared in the trial court (and on the appeal) in propria persona (never a good sign for the defense).

The allegations cited by the court showed classic signs of an alter ego  case:  The defendant’s deposition testimony revealed that he was the general manager of the defunct corporation, but he did not remember whether he had contributed any funds when he formed the corporation or  whether the corporation had ever issued shares. He did not know whether the corporation had any directors, had by-laws or minutes, had a bank account, or had filed tax returns. The defendant acknowledged that the defunct corporation did not have the money to pay for goods purchased from the vendor. Although the court’s opinion on this point is not clear, presumably it meant that the corporation did not have the money to pay for goods purchased from the vendor at the time it ordered the goods since that would be a fact that would indicate that recognizing the corporation would promote an injustice.

The individual argued that the alter ego claim belonged to the bankruptcy estate because the alter ego claim  could establish a basis of liability for all corporate debts, the recovery for which should be available to all creditors through the bankruptcy, and therefore, the state court action should be stayed. The trial court allowed the action to proceed to trial, however, and found that the individual defendant was liable to the creditor as the corporation’s alter ego.

In the published portion of the opinion, the court of appeal affirmed, concluding that the creditor’s action to hold the individual liable as an alter ego for a creditor’s substantive causes of action against a bankrupt corporation was not the property of the bankruptcy estate. In so holding, the court cited and followed Ahcom, Ltd. v. Smeding, the recent Ninth Circuit U.S. Court of Appeals decision (noted on this blog) as well as a number of cases that Ahcom cited.

Thus, the Ninth Circuit and a California court of appeal agree that an alter ego claim belongs to the creditor and is not an asset of the estate of a bankrupt corporation.

Comment

The alter ego doctrine is also known as “piercing the corporate veil.” Just because a creditor is able to establish grounds for a piercing claim, however, that does not mean that the corporation is not otherwise valid. One creditor of a defunct corporation or LLC may have the right to pierce the corporate veil while another creditor of the same entity might not. One of the pillars of a piercing claim is that it would promote an injustice not to treat the corporation as an alter ego of the owner. What is an injustice as to one creditor might not be as to another. It will therefore depend on the facts and circumstances.

Although a piercing or alter ego claim usually refers to holding a shareholder of a corporation liable for its debts, the fact that a corporation has never have issued stock does not preclude a court from finding that an individual involved in the business of a corporation is liable for its debts. Indeed, the failure to issue stock is routinely cited by courts as a factor tending to indicate that piercing is an appropriate remedy.

This case, along with Ahcom, Ltd. v. Smeding,  puts the final nail in the coffin of the notion that alter ego claims against shareholders of corporations (or members of limited liability companies) belong to the bankruptcy estate. They don’t. The claims belong to the creditors, who are free to pursue them.

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In Toho-Towa Co., Ltd., v. Morgan Creek Productions (2013) 217 Cal. App. 4th 1096, the court held that the assets of one business entity could be used to satisfy the obligations of a different, but related, business entity. This case deals with the “single enterprise” theory (also known as the “greater enterprise theory) of liability for related business entities, which permits a court to disregard the separateness of the entities so that the assets of one entity can be used by creditors to satisfy the liabilities of another.

Toho-Towa, a Japanese company, negotiated with Morgan Creek Productions, a Delaware corporation, to acquire Japanese distribution rights to a motion picture, The Good Shepherd. After the parties had reached agreement as to the terms of the distribution deal, Morgan Creek’s general counsel told Toho-Towa that Morgan Creek International B.V., a Netherlands company, rather than Morgan Creek, would grant Toho-Towa the distribution rights under the agreement, and that a third entity, Morgan Creek International Ltd., a Bermuda corporation, would guarantee the Netherlands company’s contractual obligations to Toho-Towa.

The general counsel assured Toho-Towa that the Netherlands company and the Bermuda corporation would have sufficient assets to meet any financial obligations Toho-Towa might be owed with respect to the motion picture. As a consequence of these assurances, Toho-Towa entered into a written agreement with the Netherlands company to distribute the motion picture in Japan. Pursuant to the terms of the distribution agreement, the Netherlands company ended up owing Toho-Towa approximately $4.5 million for expenses advanced to distribute the motion picture. Toho-Towa submitted its invoice to the Netherlands company requesting payment of this amount. Toho-Towa’s invoice was forwarded to Morgan Creek’s chief financial officer, who advised Toho-Towa by email that he was “speaking with our owner, Mr. Jim Robinson, re the payment date.” The invoice was never paid.

Toho-Towa initiated an arbitration proceeding against the Netherlands company and the Bermuda corporation and received an award that was confirmed by the court, resulting in a $5.8 million judgment (including interest and attorney’s fees). Neither the Netherlands company nor the Bermuda corporation satisfied the judgment entered against them.

Through discovery in aid of execution of judgment, Toho-Towa learned that the three Morgan Creek entities were owned by a single individual, James Robinson; that the work of the Netherlands company and the Bermuda corporation was performed by employees of Morgan Creek, the Delaware corporation; and that the companies were operated in such a way that no money flowed to the foreign Morgan Creek entities. Based on this information, Toho-Towa moved, pursuant to CCP § 187, to add Morgan Creek to its judgment against the Netherlands and Bermuda companies on the theory that Morgan Creek was the alter ego of the other two entities.

The ability under § 187 to amend a judgment to add a defendant, thereby imposing liability on the new defendant without trial, requires both (1) that the new party be the alter ego of the old party and (2) that the new party had controlled the litigation, thereby having had the opportunity to litigate, in order to satisfy due process concerns.

The court found the following factors relevant to its conclusion that Morgan Creek was the alter ego of the Netherlands and Bermuda companies:

1. The entities were all owned by the same person, James Robinson.

2. Robinson was the only person with authority to resolve the dispute with Toho-Towa.

3. The Bermuda company had no employees and no bank account.

4. The Netherlands company’s financial arrangements were such that it never received any money. Rather, all of its licensing income went directly to the Bermuda company’s lender.

5. Employees of Morgan Creek negotiated the foreign licensing deals on behalf of the other entities.

6. Brian Robinson, the owner’s son, sold television rights for the international film library owned by the Bermuda company, even though he was not employed by the Bermuda company.

7. Morgan Creek’s general counsel handled the legal affairs of the Netherlands and Bermuda companies, including drafting contracts and providing legal consultation, though he was not employed by either of these companies.

8. Morgan Creek’s chief financial officer, who was not employed by the Bermuda company provided financial services to it at least once a month, while Morgan Creek’s in-house accountants routinely prepared its financial statements.

9. Morgan Creek had control over the underlying arbitration, by selecting counsel, receiving legal bills, reviewing pleadings, consulting on strategy decisions, and designating one of its own officers as the person most knowledgeable as to why the Netherlands and Bermuda companies did not pay the money they owed to Toho-Towa.

The court said that the “single-business-enterprise” theory is an equitable doctrine applied to reflect partnership-type liability principles when corporations integrate their resources and operations to achieve a common business purpose.

The court found that the evidence supported the trial court’s conclusion that the Morgan Creek entities, though formed as separate corporations, were operated with integrated resources in pursuit of a single business purpose, and that Morgan Creek so dominated the finances, policies and practices of the other two companies that the other two companies latter had no separate “mind, will or existence” of their own, but were merely conduits through which Morgan Creek conducted its business.

A necessary element of alter ego cases is that there be fraud or injustice that would be avoided by disregarding the corporate form. The court found substantial evidence for the conclusion that it would be inequitable to uphold the Netherlands company’s separate existence under the circumstances of this case.

Toho-Towa negotiated the distribution rights to the motion picture with Morgan Creek. When that negotiation was concluded, Morgan Creek told Toho-Towa that the contract would actually be with the Netherlands company, not Morgan Creek, because this was how Morgan Creek conducted its distribution business. Morgan Creek assured Toho-Towa that there would be sufficient assets to pay Toho-Towa any monies due under the agreement. Toho-Towa was not told and did not know that the Netherlands company’s operations were structured by Morgan Creek in such a way that it never received any money from its licensees and thus would not have funds to meet its payment obligations under the agreement.

These factors combined to fulfill the requirements for the use of the single-enterprise doctrine to disregard the corporate form in this case.

Richard G. Burt, Attorney and Counselor at Law is available to answer your questions about business entity assets. Contact our offices today.

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California limited liability companies (LLCs) and California corporations are creatures of statute, and their failure to comply with statutory requirements can lead to their rights, powers, and privileges being suspended by the state.

Annual Report to Secretary of State

Each California LLC and each California corporation must file an annual statement of information with the California Secretary of State. In the case of an LLC, the annual statement includes the business address of the LLC, the names and addresses of the managers, the agent for service of process, and the LLC’s line of business. In the case of a corporation, the annual statement includes the business address of the corporation, the names, and addresses of the directors and principal officers, the agent for service of process, and the corporation’s line of business. Concurrently with the filing of the annual statement, the entity must tender payment of the annual filing fee. If the fee is not tendered (or if the check bounces), the statement is not filed.

If a California LLC or California corporation fails to file the annual statement in a timely fashion, a $250 penalty can be imposed. The Secretary of State will usually send a notice to the entity’s mailing address on file with the Secretary of State advising of the failure to file, but the failure of the Secretary of State to send the notice (or the failure of the entity to receive the notice at the right address) has no effect on the penalty. For example, if a corporation moves from San Jose to Sunnyvale and does not update its mailing address with the Secretary of State, it may not receive any notice from the Secretary of State. In that case, it won’t be excused from paying the penalty if one is due. It is the responsibility of the entity to keep track of when its annual report is due and to file it whether or not it receives a notice.

If the entity continues to be delinquent in filing, the Secretary of State will send a notice advising that the entity will be suspended and giving 60 days to cure the delinquency. If the delinquency is not cured, the rights, powers, and privileges of the entity will be suspended.

Richard Burt offers the service of calendaring, preparing, and filing annual statements for clients who choose it. In the case of a corporation, this service is typically coupled with the preparation of basic annual minutes, which satisfies corporate law requirements and can reduce the prospect of a shareholder becoming personally liable for the obligations of the corporation. If you have a California LLC or a California corporation, call or email Mr. Burt for professional assistance in the annual maintenance that such an entity requires.

Failure to File Tax Returns or Pay Taxes

Suspension of the rights, powers, and privileges of an LLC or of a corporation can also occur as a result of a failure of the LLC or the corporation to file tax returns or to pay taxes and, if applicable, penalties, fees, and interest.

Although an LLC is a pass-through entity and does not pay income tax, it must pay a minimum tax of $800 per year and file a California tax return, even if it is a single-member LLC that is a “disregarded entity” for income tax purposes. An S corporation must also pay taxes to California and file a California tax return even though it normally pays no federal income tax.

If a California LLC or corporation has its rights, powers, and privileges suspended by the state, the entity loses the power to conduct its business, it cannot sue in court to enforce contracts, and the parties operating the business run a substantial risk of being held personally liable for the obligations of the business.

Moreover, the Franchise Tax Board (“FTB”) is required to impose a penalty of $2,000 per taxable year whenever a California LLC or corporation fails to file a tax return within 60 days after the FTB sends the taxpayer a notice and demand to file the required tax return. The penalty can be abated if the failure is due to reasonable cause and not willful neglect.

Thus, the consequences of suspension are significant and should be avoided by complying with the legal requirements.

The suspension can be lifted, restoring the powers of the entity to conduct its business and restoring its right to sue to enforce contracts (and, not so incidentally, mitigating the risk of the parties operating the business being held personally liable for the obligations of the business). The lifting of the suspension is through a process (inaptly) called “revivor.” All state taxes, penalties, and interest owing will have to be paid to obtain a revivor.

Richard Burt has experience in helping business entities lift their suspensions and obtain certificates of revivor. If you have a California LLC or corporation that has been suspended, call or email Mr. Burt for professional assistance in obtaining a certificate of revivor.

Abandonment vs. Dissolution of the Entity

If the business of the LLC or corporation has been wound up, it is advisable to file for dissolution as soon as possible. There are a number of advantages to dissolving formally. The most immediate advantage is that the obligation to file annual statements and tax returns ends! Ignoring the statutory requirements and letting the state suspend the LLC or corporation (sometimes referred to as the “poor man’s dissolution”) is a bad idea. The president of the corporation has a statutory obligation to see that the tax returns of a corporation are filed, and failure to do so can personally expose the president to a penalty of $5,000 per year. Furthermore, the failure to dissolve formally can have consequences not intended or foreseen at the time the entity is abandoned.

Richard Burt has experience in helping business entities wind up and dissolve. If you have a California LLC or corporation that has gone out of business or is about to do so, call or email Mr. Burt for professional assistance in dissolving the entity and minimizing the exposure of personal assets to the claims of creditors of the LLC or corporation.

For answers to your questions about suspension of corporate powers in California, contact Richard G. Burt, Attorney and Counselor at Law.

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In Federal Trade Commission v. Commerce Planet, Inc. (9^th Cir. March 3, 2016) 16 C.D.O.S. 2355, the Federal Trade Commission (FTC) sued Commerce Planet, Inc., and three of its top officers for violating § 5(a) of the FTC Act, which prohibits unfair or deceptive business practices (15 U.S.C. § 45(a)). The company and two of the individual defendants settled with the FTC. The remaining defendant, appellant Charles Gugliuzza, elected to stand trial. After a 16-day bench trial, the district court found that Commerce Planet had violated § 5(a) and held Gugliuzza, the company’s former president, personally liable for the company’s unlawful conduct. The court permanently enjoined Gugliuzza from engaging in similar misconduct and ordered him to pay $18.2 million in restitution.

Gugliuzza challenged the validity of the restitution award. Among other things, he contended that the district court either lacked the authority to award restitution at all or, at the very least, had to limit the award to the unjust gains he personally received, which in this case totaled roughly $3 million.

The federal courts have established a two-pronged test for determining when an individual may be held personally liable for corporate violations of the FTC Act. The FTC must prove that the individual: (1) participated directly in, or had the authority to control, the unlawful acts or practices at issue; and (2) had actual knowledge of the misrepresentations involved, was recklessly indifferent to the truth or falsity of the misrepresentations, or was aware of a high probability of fraud and intentionally avoided learning the truth. The court found that the FTC’s evidence satisfied both prongs of this test.

Gugliuzza contended that any such award must be limited to the unjust gains each defendant personally received. The court disagreed, holding that he could be held jointly and severally liable for the full amount of the award against the corporation, not just the amount he received as a result of the corporation’s unlawful conduct.

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As previously posted on this blog, California law was changed (AB 2503) to allow the state to dissolve entities administratively instead of allowing zombie entities to remain on the rolls permanently.

A word to the wise:  Abandoning the entity and awaiting an administrative dissolution is not a recommended alternative to affirmatively taking steps to dissolve an entity when it has reached the end of its useful life. An administrative dissolution can require years to take effect, and the failure to take steps to dissolve an entity might in some circumstances have an adverse effect on the owners.

The news here is that the Franchise Tax Board (FTB) has announced that, since January 1, 2019, when the FTB established the Voluntary Administrative Dissolution Program, the FTB has administratively dissolved 1,500 corporations and limited liability companies (LLCs). Given the large number of zombie corporations and LLCs, this seems like a small number for a two and one-half year period. One wonders whether the number of zombie corporations and LLCs has grown during the period since the inception of the program.

To see the original post on this topic, click this link.

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