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The Ralite Decision: Avoiding personal liability for Unpaid Corporate Franchise Tax during a ‘Walk Away’ type Dissolution

Table of Contents

    Date: 08/24/12

    Topic: Taxation

    In Ralite, the corporation had approximately $106,000 in cash. The two shareholders took the cash as a pay out in the form of a dividend and abandoned the corporation without having paying the franchise tax. The shareholders failed to formally dissolve the corporation with the Secretary of State and the Franchise Tax Board (FTB) subsequently sued for the tax owed.

    On appeal the FTB conceded that no law existed to pierce the corporate veil and hold the shareholders personally liable since neither had expressly assumed the liability. Therefore, any recovery for the back taxes would have to be based in equity for fraudulent conveyance. Consequently the FTB had to prove all of the following before the shareholders could be held liable for the corporation’s franchise tax:

    • The corporation transferred property to the shareholder(s) for less than full and adequate money
    • At the time of the transfer and at the time the shareholder liability was asserted, the corporation was liable for the tax
    • The transfer was made after liability for the tax was accrued, whether or not the tax was actually assessed at the time of the transfer
    • The corporation was insolvent at the time of the transfer or the transfer left the corporation insolvents, and
    • The FTB had exhausted all reasonable remedies against the corporation.

    In the case of Ralite, all the conditions were met, therefore the shareholders were liable for the corporation’s franchise tax.

    Using the Ralite decision as a guide, be mindful of the following events. First, the shareholder(s) abandon the corporation and fail to formally dissolve the entity with the Secretary of State within 12 months of filing the final return with the FTB. Second, the FTB sends the corporation a Demand to File notice. Third, the FTB begins billing the corporation, which no longer has any assets for the FTB to collect form. Fourth, the FTB comes to the shareholder and demands payment. Here is when to invoke theRalite decision, explaining that the taxpayer did not take compensation that was not owed. In response enclose

    • A copy of the final balance sheet, which probably includes loans from shareholders and capital stock as well as a negative earnings account;
    • A list of assets with book value and fair market value. Indicate which shareholders took which assets; and
    • A list of loans from each shareholder to the corporation, debts each shareholder paid, and basis of each shareholder’s capital stock.

    Upon showing that the shareholder did not receive any more than was owed the FTB will generally close the account.

    One major pitfall to avoid is the business that is still in business. Sole proprietors may be held liable as transferees for delinquent corporate taxes unpaid before a change or transfer. Thus, it is important to draw a distinction between abandonment of a corporation versus continuing the business as a sole proprietor. Corporate property taken by the shareholder to use in a business includes but is not limited to: notes and accounts receivable, inventories, real and personal property, goodwill, and client lists.

    It is possible to apply Ralite to walking away from a limited liability company (LLC) because a LLC has limited liability like a corporation. However, Ralite does not apply to a limited partnership (LP) because the general partner of an LP is always liable for the debts of the LP.

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