In most cases, a financially troubled business will face some difficult choices, including which creditors to pay and which to defer. The Federal and State taxing authorities are often among these creditors. As we have seen on other occasions, a business’s decision to defer the payment of State taxes may have significant legal and, ultimately, economic consequences.
Unfortunately, these consequences may also be visited upon an otherwise healthy business that has inadvertently overlooked a State tax payment or filing obligation. One consequence that arises under these circumstances, and of which most tax advisers are aware, is the dissolution of 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 State law.
I often encounter taxpayers and advisers who believe that a dissolution by proclamation results in the taxable liquidation of the corporation for Federal income tax purposes – in other words, that the administrative dissolution results in a liquidating distribution that is taxable to both the corporation and to its shareholders. Fortunately, they are mistaken, as the IRS recently confirmed.
Taxpayer incorporated under State A law on Date 1. Taxpayer was administratively dissolved by State A on Date 2 for failure to file a Year 1 annual report and to pay an annual franchise tax. During the period in which Taxpayer was unaware of this dissolution (the ruling does not tell us how this came to be, as the State presumably sent notices to the corporation),Taxpayer continued to file IRS Form 1120 (the Federal corporate income tax return) and to pay all corporate taxes as they came due. Following discovery of the dissolution in Year 2, Taxpayer reincorporated in State A on Date 3.
Dissolved in the Eyes of the IRS?
According to the IRS, the “core test” of corporate existence for purposes of Federal income taxation is always a matter of Federal law. Whether an organization is to be taxed as a corporation under the Code is determined by Federal, not state, law. A corporation is subject to Federal corporate income tax liability as long as it continues to do business in a corporate manner, despite the fact that its recognized legal status under state law is voluntarily or (as in the case of Taxpayer) involuntarily terminated.
Thus, because Taxpayer continued to act as a corporation for Federal tax purposes, its status as a corporation for such purposes was not terminated by reason of its having been administratively dissolved by State A.
It should be noted, however, that while the a corporation’s Federal tax status is determined under Federal law, its legal powers, rights, and privileges are determined by the law of the State under which the corporation was organized. When these powers are suspended by that State by virtue of the corporation’s administrative dissolution, the corporation cannot exercise these powers, including the right to prosecute or defend a Federal tax action.
The corporation in the above ruling was fortunate not to have known of its involuntary dissolution, and to have continued to act as a corporation, at least from a Federal tax perspective. Query how it would have acted if it had been aware of the dissolution. The fact that it felt compelled to request a private ruling from the IRS as to its continued corporate status probably evidences an unwarranted concern among its tax advisers, that is shared by many others, that a dissolution by proclamation may have resulted in the taxable liquidation of the corporation for Federal income tax purposes.
A little research could have saved them the uncertainty, time, and effort.