It’s great to be in business when things are going well. When things start to go badly, however, they can quickly cascade out of control, with reduced cash flow leading to the diversion of trust fund taxes, like sales and employment taxes, toward the payment of business expenses.  Additionally, a struggling business owner in need of operating capital will often forego the remittance of business income taxes in favor of satisfying trade debts. ostrich

When the “deferred” income taxes are owed by a corporate taxpayer to the State under the laws of which the corporation was formed, there may arise at least one serious Federal income tax consequence of which the corporation and its shareholders should be aware.

Dissolution by Proclamation

“Federal income tax consequence for failing to pay state taxes?” you may ask.

Most New York tax advisers are aware that if a New York corporation does not file franchise tax returns, or pay franchise taxes, for two or more years, the New York Secretary of State may dissolve the corporation by proclamation, at which point the legal entity of the corporation ceases to exist, as do any legal rights to which it was entitled as a corporate entity under New York law. These lost rights include, of course, “the right to sue in all courts.”

Many taxpayers and advisers believe that a dissolution by proclamation must result in the taxable liquidation of the corporation for Federal income tax purposes.  Fortunately, they are mistaken. Unfortunately, however, as two recent Tax Court decisions show, these corporations will encounter other difficulties with respect to Federal tax consequences.

Just the Facts

In each of the decisions, the respective taxpayers were California corporations whose corporate privileges were suspended by the State for failure to pay State franchise tax.   Additionally, the IRS had mailed to each Taxpayer a notice of deficiency (a so-called “90-day letter”) determining Federal income tax deficiencies, penalties, and additions to tax. Each Taxpayer timely filed a petition (i.e., within 90 days of the notice) in the Tax Court challenging the IRS’s determinations.  In most cases, the timely filing of its petition with the Tax Court would have enabled Taxpayer to contest the asserted tax liabilities without having to first pay them; this is a major reason why most taxpayers opt to contest a tax liability in the Tax Court rather than in another forum in which payment would have to be remitted before a challenge could be made.

In each case, the IRS filed a motion to dismiss the Taxpayer’s petition for lack of jurisdiction, alleging that Taxpayer lacked the capacity to sue at the time the petition was filed. Also in each case, the CA Franchise Tax Board issued to each of the Taxpayers a certificate of reviver, retroactively reinstating the Taxpayers’ corporate existences (on account of the satisfaction of their respective past-due tax liabilities). However, these certificates were issued after the end of the 90-day period.

And the Court Says…

The Tax Court held for the IRS in both cases, reasoning that it lacked jurisdiction over the cases—notwithstanding the otherwise properly filed petitions.

According to the Court, whether a corporation has capacity to engage in litigation in the Court is determined by the law under which the corporation was organized. The Taxpayers’ petitions, the Court stated, were filed at a time when their corporate powers, rights, and privileges were suspended by the State of CA. A suspended corporation, it stated, cannot prosecute or defend an action while its legal status is suspended.  Furthermore, the Court stated, a revival will not restore a taxpayer’s capacity to litigate a Tax Court case when the date of the revival is beyond the 90-day period in which a petition in the Court was required to be filed.

The Tax Court noted that the CA courts have been clear that statutes of limitations create substantive defenses that may not be prejudiced by a corporate revival. As a result, the Court found that the Taxpayer lacked the capacity to file a valid petition that would confer jurisdiction over the matter on the Tax Court.

The Court further explained that the timely filing of a petition in response to a notice of deficiency is a statutorily-imposed jurisdictional requirement. The Taxpayer’s suspension under CA law deprived it of the capacity to sue, and thus prevented its corporate revival from prejudicing the IRS’s defense of lack of subject matter jurisdiction. Pointing out that it lacked the authority to relieve the Taxpayer from the jurisdictional requirement, the Court granted the IRS’s motion to dismiss for lack of jurisdiction.

What’s Next for Taxpayer?

As a result of its loss in the Tax Court, and as a matter of Federal tax law, the Taxpayer will be assessed the additional tax, interest and penalties asserted by the IRS. The IRS will then begin collection action against the Taxpayer by demanding payment. If the Taxpayer fails to pay after this demand, a lien will arise (as of the time the assessment was made) in favor of the IRS upon all of the Taxpayer’s property. The levy process will follow and the tax will be collected.

If the Taxpayer’s objection to the additional taxes is defensible, it may file a refund claim with the IRS, and then bring an action in U.S. district court.

Takeaway

A troubled business is faced with many choices. Whom does it pay? Whom does it defer, or just ignore? There are trade creditors, there are institutional lenders, and there are Federal and State taxing authorities.

Each decision will have consequences. In other posts, we have examined the personal liability that may be imposed upon the owner of a business in respect of the trust fund taxes owed by the business.  We recently considered an owner’s transferee liability for the income taxes of a corporate business that has been liquidated.

Almost invariably, the owners of the troubled business believe that, if they can just sustain the business a bit longer, it will turn the corner and become profitable again, at which point the business will either satisfy its creditors, including the taxing authorities, or work out a settlement (perhaps through a reduction of the amount owing and/or the implementation of a payment plan).

Most taxing authorities will suggest that such a business should cease operations altogether, rather than continue to neglect its tax obligations and allow them to grow exponentially (consider the power of daily compounded interest, plus penalties).

The ostrich is among my least favorite creatures. So is the ignorant or unrealistic taxpayer. Early realization of the tax issue is the key, shortly followed by planning, and immediate implementation of the plan. The preservation of options has to be one element of that plan, and should include the preservation of a corporation’s legal status. Without that, a corporate taxpayer cannot contest a liability in Tax Court, as we saw above. Nor can it pursue its own trade debtors – for example, customers who owe it money for services rendered or products delivered. This, in turn, will make it more difficult for the corporation to pay its own debts and turn that corner that its owners keep looking for.