Don’t Get Snared In This Post-Dissolution LLC Tax Trap

Knowing what to do when a business venture ends can save you a world of tax hurt, and get you back on your feet faster.

By either their own experience or that of their colleagues, entrepreneurs live with this hard fact: Not every business is going to succeed.  Lots of those that fail will have been operated as limited liability companies, those business associations combining properties of both partnerships and corporations.   To see how bad things can get consider the following example.

Five years ago Jack formed LLC to own and operate his restaurant.  As a sole proprietor he used his social security number rather than an EIN for all his trustee (i.e., sales) tax filings.  The LLC never filed a separate return and Jack recognized all its income on his personal federal and state tax returns.

And then hard times came and Jack started making ends meet by sometimes neglecting to pay over to State all the taxes he owed.  He paid rent instead, and his employees, and bought supplies and time for his business.

Jack also skipped paying his LLC’s annual registration fees and eventually State’s Secretary of Commerce administratively dissolved it.  Jack got a formal, certified letter but nothing much else happened and the restaurant continued operating as usual.

And then State’s tax collectors began sending notices demanding payment of the back taxes.  Eventually they threatened to seize the restaurant outright.  The restaurant, although losing money and underwater on its balance sheet, had sufficient value in its liquor license and other assets to pay the tax debt.

With no more cards to play, Jack filed for Chapter 13 bankruptcy.  The Bankruptcy Court then issued an automatic stay of collection activity to all Jack’s creditors, including State and its tax collectors, while the petition was processed through federal court.

Jack breathed a sigh of relief.  Having found a bit of breathing room, he began thinking about how to set things right.  And then one morning State’s tax collectors showed up, complete with an armed police escort, and seized the restaurant.  They changed the locks on all the doors, posted bright orange signs across the front, and barred Jack from ever entering again.

So, how could this happen?  How did Jack lose the restaurant even while the Bankruptcy Court’s stay was in full effect?

First, State’s tax collectors were able to obtain an Order of Entry and levy the restaurant by bringing their action in State court (not the federal Bankruptcy Court).  To do so, they titled their action in the name of the LLC.  Jack’s bankruptcy stay only protected Jack personally.

Recall that limited liability companies are hybrids of sole proprietorships (or partnerships) and corporations.  And viewed as a corporation Jack’s LLC was a separate individual,  one who had not filed for bankruptcy.  The chapter 13 stay, in essence, applied only to Jack-person and not to LLC-person.

So even though Jack protested that for all those prior years State’s tax collectors had treated LLC as not separate from Jack, he did not prevail.  The election to be taxed as a sole proprietorship is only a means for filing tax returns.  In the seizure State had acted as any other creditor could have done, seeking assets to make good a debt owed by LLC.

Second, Jack asked how could any creditor proceed against an LLC that had been administratively dissolved?  Surely the alleged separate LLC-person no longer existed.

But here, too, Jack was doomed.  In State the process of ending a limited liability company has three stages: Dissolution, Winding Down, and Cancellation.

  • Dissolution of an LLC can be undertaken voluntarily by its members, or in certain circumstances forced upon it by State.
  • Once dissolved, Winding Down commences.  From now on the LLC cannot conduct any new business and must focus only on paying its creditors, filing final tax returns, distributing assets, and so on.
  • After that, an LLC can apply for Cancellation of its certificate of organization.  When granted, that is the moment…the only moment…when the limited liability company ceases to exist.

Here, State had administratively dissolved Jack’s LLC for non-payment of the annual registration fee.  At that point Jack should have commenced winding down (he didn’t).  And he certainly never sought Cancellation.  As a result his LLC continued and that’s why State’s tax collectors (and any other creditors) could go after it.

One final comment:  The period allowed for winding down a true corporation is set by statute in most states (typically, three years), after which cancellation may occur automatically.  Despite their hybrid nature, however, a limited liability company is often disqualified for this eminently reasonable procedure.

The result is the infamous living dead – zombie – company.  It hasn’t terminated but it can’t continue.  It persists, apparently, only to serve as a never-ending target for creditors.

This article is for informational purposes only and does not constitute legal advice.  You should consult a qualified attorney before taking any action.