Perils of Dissolution, or Hey, FTB, Where’s My Dough?

Sometimes a California limited liability company (LLC) or California corporation dissolves and files a final tax return which shows it has a refund coming, but the refund is $800 short. How could this happen? It’s because the Franchise Tax Board (FTB) may deduct $800 and apply it to next year’s taxes.

Let’s say that a business entity files a tax return and has a refund coming. In that case, the FTB computer looks to see if the business entity had paid the tax for the next year (estimated tax for a corporation). If the next year’s tax payment is past-due, the FTB may take $800 out of the refund and apply it to the next year’s tax. The intent is to help the taxpayer avoid penalties and interest for late payment of the tax for the next year.

But if the entity is dissolving and filing its final tax return (and the appropriate box on the tax return is marked to show that it’s the final tax return), there shouldn’t be a next year for the entity, let alone a tax for that next year.

Here’s the rub. Although a California LLC or corporation files a tax return marked “Final,” the termination of the entity for tax purposes does not occur until the proper paperwork is filed with the California Secretary of State. In the case of an LLC, the minimum paperwork is ordinarily a certificate of cancellation. In the case of a corporation, the minimum paperwork is ordinarily a certificate of dissolution. In some cases, additional paperwork might be needed, particularly if the entity has been delinquent on its filings with the Secretary of State.

If the paperwork is not timely filed, the business entity continues to exist for tax purposes until the next tax year. (And it will continue until it files the correct paperwork with the Secretary of State.) In that case, it incurs the next year’s taxes. This applies even if the tax return filed was marked “final.”

Once the Secretary of State notifies the FTB that the correct paperwork has been filed, assuming the correct paperwork has been timely filed, the FTB should remit the $800 balance to the taxpayer (less, of course, any other amount that may be owing).

But if the taxpayer neglects to file the paperwork on time or never files the paperwork with the Secretary of State, then the $800 deducted from the tax refund will be consumed by being applied to the next year’s tax. And the business entity will probably incur penalties and interest in succeeding years if the paperwork is not filed before the end of the next year.

Filing the correct paperwork with the Secretary of State prior to filing the final year’s tax return may avoid this problem. There are other pitfalls to terminating a California entity, and it can pay to have competent legal assistance in the process.

If you have a California business entity to wind up, dissolve, or terminate, I can help.

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LLC Annual Fee Clarified by Franchise Tax Board

A limited liability company (“LLC”) doing business in California (whether organized under California law or the law of another state) must pay an LLC annual fee on its “total income from all sources derived from or attributable to this state.” (The annual LLC fee is really a tax, but the legislature didn’t want to call it a tax, so it’s an LLC fee. But it still quacks like a tax.)

The LLC annual fee is in addition to the $800 flat annual franchise tax. The LLC annual fee is graduated, starting at $900 for LLCs with total income of $250,000 and topping out at $11,900 for LLCs with total income of $5 million or more.

The Franchise Tax Board (FTB) recently ruled on how to calculate the “total income” in the case of an LLC taxable as a partnership that sells real property. FTB Legal Ruling 2016-01 (July 14, 2016).

If the LLC holds the real property for sale to customers in the ordinary course of business (i.e., it’s a “dealer” in real property for income tax purposes), then according to the FTB, the total income for the purpose of calculating the LLC annual fee includes the adjusted basis of the real property (not just the gain realized).

If the LLC holds the real property for investment (and not for sale to customers in the ordinary course of business), then the total income for the purpose of calculating the LLC annual fee is the gain realized (and the adjusted basis of the real property is not included in the calculation).

The reason for the difference is that “total income” for purposes of calculating the LLC fee is defined in Revenue & Taxation Code § 17942(b)(1)(A) as “gross income, as defined in Section 24271, plus the cost of goods sold that are paid or incurred in connection with the trade or business of the taxpayer.” If the LLC is a dealer in real property, then it’s in a “trade or business,” and the adjusted basis of the real property is part of cost of goods sold. If the LLC holds the real property for investment, the income from the sale of the real property is not from a “trade or business,” and the concept of “cost of goods sold” does not apply.

Here’s a link to the FTB ruling:

FTB Legal Ruling 2016-01

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Here’s One Way Not to Pay Taxes – Legally!

California charges a minimum franchise tax of $800 each year. This is a tax on the privilege of being a corporation. It doesn’t matter whether the corporation is profitable or even if it has any revenue. The state wants its $800 from every corporation every year, and if it’s not paid, the state will suspend the corporation. There is one exception, however.

If you’re planning on forming a corporation near the end of the year, it can sometimes pay to wait a bit. Corporations with a first tax year of 15 days (or fewer) will not have to file a tax return or pay the $800 tax if the corporation conducts no business during those remaining 15 (or fewer) days in its first tax year.

Let’s say that a business owner is planning on incorporating in December (and let’s assume, as is common, that the corporation’s tax year is the same as the calendar year). If the articles of incorporation are filed on December 16 (or earlier), the corporation will have to file a tax return and will owe the $800 franchise tax for that year, even though it existed for only 16 days of that year and even if conducted no business!

On the other hand, if the articles are filed December 17 (or later that month) and the corporation conducts no business that month, no tax return is required and no $800 tax is due for that year.

Not all corporations have a tax year (that is, a fiscal year) that coincides with the calendar year (Jan-Dec.). The following table shows the earliest date in a month when a corporation’s articles of incorporation can be filed with the California Secretary of State and there will be 15 days or fewer in the tax year.

Month Incorporated and Tax Year Ending on: Day of the Month:
January, March, May, July, August, October, and December (31-day months)  

 

17th or after
April, June, September and November (30-day months) 16th or after
February (29-day month) 15th or after
February (28-day month) 14th or after

The conduct-no-business requirement is a bit tricky. To take advantage of the exception, the corporation must conduct no business at all during the remainder of the month. Doing anything more than simply filing the articles raises a question as to whether the corporation is doing business. To answer that question, professional guidance should be sought.

If you are planning to form a corporation, call Richard Burt first and ask about an entity-selection consultation. A corporation is not always the best form of business organization, even for those looking to limit their liability.

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FTB Tax Clearance Certificates

When a business is required to deduct and withhold taxes and remit them to the Franchise Tax Board (FTB), a successor to the business can be responsible for paying the amount owing to the FTB  if the business does not pay them.

Who is a successor? A “successor” is anyone who acquires a substantial portion of the assets or the business.  It doesn’t matter how the assets were acquired. They can be purchased, transferred, distributed to shareholders or other owners in liquidation, or inherited.

By virtue of Revenue & Taxation Code section 18669, the obligation to pay required withholding tax (and interest and penalties, if applicable) is transferred with the assets. The successor’s liability is limited to the fair market value of the assets acquired. Thus, if a seller’s liability to the FTB is $100,000 and the business is sold in an arm’s-length transaction for $60,000, the buyer is only liable for $60,000. But that’s $60,000 more than the buyer was expecting!

How to avoid this pitfall?  A purchaser (or other potential) successor can submit a written request to the FTB for the amount of withholding taxes, interest, or penalties due. This is customarily referred to as a “tax clearance certificate.” The FTB has 60 days to issue a tax clearance certificate or a statement showing the amount due. Sixty days, however, can be a long time to wait for the buyer and seller of a business. One way to deal with that delay is to get the ball rolling right away and submit the request for the tax clearance certificate as soon as possible.

If a written request for a tax clearance certificate is not made, the unpaid amount of withholding taxes (and interest and penalties, if applicable) is due the day the business or assets are acquired. If payment is not made then, a 10% penalty, based on the amount payable, can be assessed.

If the FTB does not issue a tax clearance certificate (or statement of amount due) 60 days after request is made, the FTB is deemed to have issued a certificate stating no withholding taxes, interest, or penalties are due. Thus a purchaser would have no liability for the seller’s withholding taxes, interest, or penalties. Although the buyer may be off the hook, the seller is not.

Whether or not the FTB issues a tax clearance certificate (or statement showing the amount due) within the 60-day period, the original business owner (or entity) remains liable for the amount due.

For information about Board of Equalization tax clearance certificates (for sales tax liability), see https://richardburtlaw.com/boe-tax-clearances/

For information about Employment Development Department tax clearance certificates, see https://richardburtlaw.com/edd-tax-clearances/

Posted in Buy-Sell Agreement, Mergers & Acquisitions, Purchase and Sale of a Business, Successor liability | Tagged , , | Comments Off on FTB Tax Clearance Certificates

Officer Liable for Restitution of Corporation’s Gains in Violation of FTC Act

In Federal Trade Commission v. Commerce Planet, Inc. (9th 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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Don’t go to MyFTB.com. It’s not the official site.

To access your MyFTB account, go to the FTB’s website: www.ftb.ca.gov . Note that the word “my” is NOT part of the URL.

MyFTB.com has been reported as a malware site.

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Acquirer Can Enforce Arbitration Agreement with Acquired Company Employees

The following is the text of an e-bulletin that I authored and that was published by the Corporations Committee of the Business Law Section of the State Bar of California.

Francisco Marenco was employed by 180 Connect, Inc. As a condition of employment, he entered into an arbitration agreement that required both parties to submit to binding arbitration all claims arising from the employment relationship. Subsequently, 180 Connect was acquired by DirecTV LLC in 2008. DirecTV retained 180 Connect’s employees, and Marenco continued working for DirecTV until February 2010.

Marenco brought a putative class action against DirectTV, contending that it violated state wage and unfair-competition laws. DirecTV moved to compel arbitration pursuant to the arbitration agreement signed with 180 Connect. Marenco objected, arguing that DirecTV lacked standing to enforce the arbitration agreement because it was not a party to the agreement. DirecTV responded that as a successor in interest to 180 Connect, it had succeeded to all the rights and obligations arising from 180 Connect’s employee relationships, including the arbitration agreement between Marenco and 180 Connect.

The trial court granted the motion to compel arbitration, and the court of appeal, in what it referred to as a case of first impression, affirmed, concluding that DirecTV had standing to enforce the arbitration agreement.

By suing DirecTV for unpaid wages, Marenco acknowledged the existence of an employment relationship with it. DirecTV, the surviving corporation, assumed all of the disappearing corporation’s rights and liabilities, including the obligations owed to the disappearing corporation’s employees.

Although DirecTV was not a signatory to the arbitration agreement between Marenco and 180 Connect, the court said that the agreement formed one of the terms of employment for Marenco. When Marenco sued DirecTV for violating the terms of his employment, DirecTV was entitled to invoke the arbitration clause to compel Marenco, as a signatory plaintiff, to arbitrate his claims pursuant to the employment agreement.

Citing the principle that a voluntary acceptance of the benefit of a transaction constitutes consent to the obligations arising from it, the court ruled that continued employment provides implied consent to maintaining the existing terms of employment, including the arbitration agreement.

It’s hard to conclude from the opinion whether the acquisition was a purchase of assets with an assumption of liabilities or a merger. There are discussions in the opinion to support both conclusions, but in an April 2008 8-K report filed with the SEC, 180 Connect announced that it had entered into a merger agreement with DirecTV. Consequently, while there is dictum that would support the holding applying to an asset acquisition with an assumption of liabilities, the case may be binding precedent only with respect to mergers.

If you need assistance with arbitration, buy-sell agreements, or outside general counsel, contact Attorney Richard Burt. Mr. Burt can be reached at (408) 286-7333 or by filling out the online contact form.

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Guidance on Best Practices in M&A Transactions

The Corporations Committee of the Business Law Section of the State Bar of California just published an e-bulletin that I prepared. The e-bulletin alerts attorneys to a paper written by Leo Strine, Jr., chief justice of the Delaware Supreme Court, Documenting the Deal: How Quality Control and Candor Can Improve Boardroom Decision-Making and Reduce the Litigation Target Zone. I recommend the paper highly for business lawyers, even those who don’t practice in the area of contested mergers.

If you need assistance with arbitration, buy-sell agreements, or outside general counsel, contact Attorney Richard Burt. Serving San Jose, CA and all of the San Francisco Bay area, Mr. Burt can be reached at (408) 286-7333 or by filling out the online contact form.

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Real Estate Withholding Credit for Pass-Through Entities

The California Franchise Tax Board (FTB) has recently published a reminder about credit for real-estate withholding. According to the FTB:

Pass-through business entities that pass through their income, deductions, and credits to the owners must also pass through the real estate withholding credit. What is a pass-through entity? It is an S corporation, limited partnership, or limited liability company. A general partnership is treated the same as a pass-through entity, though technically it is not one.

The FTB advises that it cannot refund that part of the real estate withholding credit that exceeds the pass-through entity’s total tax or fee due.

S corporations, limited partnerships, and LLCs may use the withholding to offset their outstanding liability, tax, or fee. Any excess withholding must be allocated to the shareholders, partners, or members.

General partnerships don’t have a California income tax or franchise tax liability and must allocate the entire amount of the real estate withholding credit to the partners.

The pass-through entity’s withholding must flow through to the shareholders, partners, or members (typically, in accordance with the allocation of gain from the sale of the real estate). The shareholders, partners, or members can claim the withholding credit against their individual tax liabilities as long as they are not themselves a pass-through entity.

For more information, see FTB Pub. 1017, Resident and Nonresident Withholding Guidelines.

If you need assistance with arbitration, buy-sell agreements, or outside general counsel, contact Attorney Richard Burt. Serving San Jose, CA and all of the San Francisco Bay area, Mr. Burt can be reached at (408) 286-7333 or by filling out the online contact form.

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Perfected Security Interest Yields to Breach of Fiduciary Duty

If a party succeeds in perfecting a security interest in personal property by breaching a fiduciary duty, the security interest may be disregarded for the benefit of the person owed the fiduciary duty.

In Feresi v. The Livery, LLC (2014) 232 Cal. App. 4th 419, Renee Feresi and James Mesa were a married couple who during the term of their marriage acquired a 25% interest in The Livery, LLC. The LLC began with four investors who owned equal shares. Mark Hartley’s family trust was an investor, and he served as the LLC’s president and managing member.

In May 2006, Feresi and Mesa were divorced, and Feresi was awarded one-half of the community’s interest in the LLC. Mesa was also required to make the monthly payments on Feresi’s home mortgage and to pay it off within five years. Mesa’s financial obligations to Feresi were secured by Mesa’s interest in the LLC and other properties.

Feresi did not file a Uniform Commercial Code Financing Statement (UCC-1) to perfect her security interest in Mesa’s share of the LLC. She instead gave Hartley and the other members of the LLC written notice that the dissolution judgment awards her one-half of Mesa’s share of the LLC and that Mesa pledged his retained share as security for his financial obligations to her. Amendments to the books and records of the LLC showed Feresi as a member with a 12.5 percent ownership interest. Corporate tax returns identify Feresi as an LLC member.

By 2008, Mesa was struggling financially and fell behind on his obligations to Feresi, his ex-wife. In October 2008, Hartley made a short-term loan to Mesa of $200,000 from the Fitzgerald-Hartley Pension Plan. Although Hartley knew Mesa’s membership share in the LLC secured his financial obligations to Feresi, Hartley nevertheless secured the loan from his pension plan by the same 12.5% membership share Mesa pledged to Feresi in 2006.

Hartley did not disclose to Feresi either that his pension plan intended to loan money to Mesa or that it would be secured by Mesa’s membership share.

Later that month, Feresi notified Hartley (as president and manager of the LLC) that she intended to enforce Mesa’s obligations to her by taking the 12.5% share of the LLC and certain other properties he pledged. She asked the family law court to compel Mesa to convey his 12.5% membership share in the LLC to her. Hartley determined that Feresi had not filed a UCC-1 financing statement to perfect her security interest in Mesa’s membership share of the LLC.

Hartley took advantage of this circumstance by filing a UCC-1 financing statement to perfect his pension plan’s security interest.

The family court subsequently ordered Mesa to transfer his interest to Mesa, which he did, and Feresi notified Hartley and the other LLC members that Mesa’s transfer was complete and that the LLC’s records should be amended to identify her as the owner of a 25% membership interest.

Several months later, Mesa failed to repay the loan from Hartley’s pension plan, and Hartley took action to foreclose on the security interest held by his pension plan. Feresi sued to stop the foreclosure. The court granted an injunction and ruled that Feresi took her interest free and clear of the security interest of Hartley’s pension plan.

On appeal, the court held that if a perfected security interest is created by breaching a fiduciary duty owed to another person, then equitable principles may be applied to give priority to an earlier unperfected security interest. The court said that Hartley was obligated to act with the utmost loyalty and in the highest good faith when dealing with any member of the LLC, including Feresi.

Hartley was not permitted to obtain any advantage over Feresi (or any other member of the LLC) by even the slightest misrepresentation or concealment. Hartley breached his fiduciary duty to Feresi by destroying the value of her security interest in Mesa’s LLC membership interest to advance his own. Hartley had actual knowledge of Feresi’s security interest in Mesa’s membership interest, knew that Mesa was in default on his obligations to Feresi, and knew that Feresi’s security interest was immediately enforceable. Hartley loaned money to Mesa, created a conflicting security interest in Mesa’s membership interest, and then surreptitiously perfected it to gain an advantage over Feresi.

Hartley took advantage of Feresi’s ignorance by concealing this from her, and betrayed her trust and confidence by perfecting his pension plan’s security interest ahead of hers. In doing so, Hartley breached the fiduciary duties of loyalty and good faith he owed to Feresi. Under these circumstances, the trial court properly refused to enforce the security interest held by Hartley’s pension plan.

Although the UCC gives statutory priority to the holder of a perfected security interest even if the holder is unjustly enriched at the expense of an unsecured creditor, the court found that the provision of the UCC that its provisions are to be supplemented by “principles of law and equity” allowed for the security interest of the pension plan to be disregarded.

Contact the offices of Richard Burt Attorney and Counselor at Law with your questions regarding Perfected Security Interests.

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