One of the best tools to limit or avoid personal liability associated with running your business in Texas is to set up a corporation, limited liability company, or a similar entity. However, many business owners set up their business entity, open a bank account, and go about their “business as usual” without timely filing the required business franchise tax reports with the State of Texas.
The Basics of The Franchise Tax
The State of Texas Comptroller website states: “The Texas franchise tax is a privilege tax imposed on each taxable entity formed or organized in Texas or doing business in Texas.” https://comptroller.texas.gov/taxes/franchise/faq/reports-payments.php
The annual franchise tax report is due May 15, and various penalties are assessed for failure to file and pay the tax by the due date. The comptroller provides a notice of forfeiture if the report and/or required tax is not paid prior to forfeiting an entity’s corporate privileges. Once an entity’s corporate privileges have been revoked, a business may continue to operate; however, the protections against liability that are afforded by maintaining the corporate form are no longer in effect. This means that corporate directors and officers may be held personally liable for debts which are incurred during the period wherein corporate privileges are revoked.
The Basics of Reinstatement
Reinstatement of corporate privileges is a fairly straightforward process. An entity must pay the penalties on its account, file franchise tax reports for the missing time periods, and obtain a letter from the Texas Comptroller showing the account has been brought current. This letter is then presented to the Texas Secretary of State for reinstatement.
Liability Issues
Even if corporate privileges are reinstated, corporate officers or directors will remain potentially liable for any contractual-type monetary debts which were “created or incurred” during the forfeiture period (between the date that a company forfeits its corporate privileges and the date that it revives them). See Tex. Tax Code Ann. Section 171.255(a). For instance, if an LLC forfeited its privileges in June 2017 and revived privileges in October 2017, but the company purchased $200,000 of materials during August of 2017 and they were signed for on behalf of the (now forfeited) entity – an officer or director could be pursued in his or her personal capacity for the materials purchase because the debt was created or incurred during the forfeiture. Some business owners mistakenly believe that reinstatement of the corporate privileges in October 2017 reaches back into time and covers the debts that were incurred during the forfeiture period. However, the Code states: “If a corporation’s corporate privileges are forfeited, each director or officer is liable for each debt of the corporation that is created or incurred in Texas after the date on which the report, tax, or penalty is due and before the corporate privileges are revived. See Tex. Tax Code Ann. Section 171.255(a).
It is also mistakenly assumed that for personal liability to exist, the director or officer must have been personally involved in the transaction which created the debt. However, as recognized by Texas courts, it is a director’s or officer’s “consent or approval of the corporate debts” in general, providing the basis of personal liability. First Nat’l Bank of Boston v. Silberstein, 398 S.W.2d 914, 915-16 (Tex. 1966). Therefore, a director or officer does not need “actual knowledge” of the debt to be held personally liable. Silberstein at 916, In re Trammell, 246 S.W.3d 815, 822 (2008).
Once exception to this general liability, found in Section 171.255(c) of the Tax Code, provides a director or officer the ability to show the debt was created (1) over his objection, or (2) without his knowledge. The officer or director has the burden to show he objected to the debt. Arguably, it would be difficult to meet this burden in court.
Exactly What Is a Corporate Debt?
It is important to know – particularly for those in the construction industry-liability during a tax forfeiture does not apply to “involuntary debts,” such as judgments obtained against an entity resulting from personal injury claims. Williams v. Adams, 74 S.W.3d 437, 442 (2002). “[S]ection 171.255 cannot be used to impute personal liability to an officer or director of a corporation for a corporate debt when the ‘debt’ at issue is a tort judgment based on negligence liability.” Williams at 442.
With regard to judgments flowing from contractual agreements, the Texas courts have expended a certain amount of energy attempting to clarify when a “debt” becomes liquidated and enforceable. In Hovel, a homeowner sued an LLC for breach of contract and DTPA violations. The Court concluded a judgment-debt is created or incurred when the conduct or contract occurs. Hovel v. Batzri, 490 S.W.3d 132 (2016). Therefore, if a specific money judgment is obtained during tax forfeiture, but the entity was in good standing when the conduct or contract occurred, then the officers and directors may not be held personally liable: “[W]e hold that, under Section 171.255 of the Tax Code, judgment-debts arising from or related to pre-forfeiture agreements and pre-forfeiture acts are considered to have been created or incurred pre-forfeiture even if not liquidated until post-forfeiture, whether the claims are expressed solely as contract claims or a combination of contract, statutory and tort claims.” Hovel at 134. The Court concluded that the contract was executed pre-forfeiture, and the breach, tortious conduct, and injury occurred pre-forfeiture, even though the specific amount of the claim was not calculated until after forfeiture. The Court, as a result of this analysis, provided the officers and directors with limited liability.
With these various arguments in mind, corporate officers and directors should make it a priority to finalize tax reports to prevent or close up any potential gaps in franchise tax reporting. However, in the event of delay – which happens for many reasons – care should be taken regarding entering into various transactions in light of the potential for personal liability.
With a concentration in business, construction and real estate law, The Cromeens Law Firm, PLLC, is committed to providing results driven, cost-effective and personalized representation to each one our clients. Contact us today to learn more about our in-depth experience and how we can assist you.
This article is intended as a general educational overview of the subject matter and is not intended to be a comprehensive survey of recent jurisprudence, nor a substitute for legal advice for a specific legal matter. If you have a legal issue, please consult an attorney.