A few years ago, I met with a new client here in San Jose about forming a corporation for his real estate management business. He wanted to use his name as the name of the corporation, e.g. John Smith, Inc., and he had no problems with using his name as the Agent for Service of Process, and having his home address as the business address on public record. Imagine my surprise when I went to the Secretary of State's database to confirm that the name was available and found that the exact name was taken by the same client at the same address. The corporation had been formed back in 1989 and had been suspended for decades.
I discussed it with the client and discovered that he had spoken with another lawyer about forming a corporation many years ago, and although he thought it was just an informational meeting, the attorney actually formed the corporation and the client didn't even know about it. If my client wanted to use the name of the suspended corporation, he would first have to revive it, in which case, he would have had to pay tens of thousands of dollars in back franchise taxes and interest. I counseled the client to walk away from the suspended corporation and simply start a new one under a different name. In this case, that was okay because he took no assets from the corporation and therefore could not be held personally liable for the corporation's taxes. However, shareholders should not walk away from a corporation without carefully considering whether the same conclusion would apply to their situation, and whether they are willing to endure the annoying tax notices to the corporation in the meanwhile.
The landmark case in this area is the Appeal of Howard Zubkoff and Michael Potash, Assumers and/or Transferees of Ralite Lamp Corporation (April 30, 1990, 90-SBE-004). In that case, the Board of Equalization stated that the only way shareholders are liable for the corporation's franchise taxes would be if the Franchise Tax Board proves that all of the following conditions were met:
- The corporation transferred property to the shareholder(s) for less than full and adequate consideration;
- At the time of transfer and when shareholder liability was asserted, the corporation was liable for the taxes;
- The transfer was made after liability for the tax was accrued;
- The corporation was insolvent at the time of the transfer or as a result thereof; and
- The FTB had exhausted all reasonable remedies against the corporation.
Source: Spidell's California Taxletter Vol. 34.11, Nov. 1, 2012
Even if a shareholder thinks he, she, or it qualifies under the Ralite conditions, and would not be held personally liable for the taxes, the shareholder must understand what the last condition means - the FTB may exhaust all remedies against the corporation in trying to get it to pay the taxes. The FTB will send the corporation a Demand to File notice, then a Notice of Proposed Assessment, and then try to collect against the corporation. Since the FTB is pursuing the corporation and not the shareholder (yet), there is no defense that the shareholder can offer. A Ralite defense is inapplicable at this stage because that is a defense by the shareholder, not the corporation. A shareholder needs to be willing to receive these documents on behalf of the corporation and not respond until the FTB eventually comes after him or her personally for payment. That is when Ralite can be invoked. And that is when the taxpayer will have to prove the above conditions are met by providing supportive documentation to the FTB. This could be a long process requiring ample time and attention from the shareholder.
If the corporation was formed back in 1989, and the shareholder clearly meets the above conditions because he wasn't even aware of the formation, walking away makes sense. However, if the corporation just failed to file a final tax return or dissolve with the Secretary of State in the last few years, the shareholder may be better off paying the back taxes and interest to avoid this hassle in the future.
The information appearing in this article does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to the author.