Going after noncompliant LLCs
California officials are on the prowl for thousands of limited liability companies that have failed to file required forms or pay fees and taxes.
Under a new state program, those LLCs face suspension if they didn’t file state income returns, pay income fees owed, pay the $800 annual LLC tax or make an information filing that is required every two years.
It’s the first time since state law allowed the popular business entities 15 years ago that California has taken steps to suspend noncompliant companies registered as LLCs.
Suspension means that a company loses the right to its name and its ability to sue or be represented in court, its contracts are unenforceable and it cannot legally do business in California, according to the Franchise Tax Board, the state tax agency.
Even if a business registered as an LLC in California never conducted business here, it continues to rack up the annual tax of $800, plus interest and penalties, until it formally cancels the registration. Out-of-state companies that registered as LLCs in California are also subject to suspension for noncompliance.
“When LLCs came about, we had many people set up LLCs -- small mom-and-pops or husband-and-wives -- and then they just never did their paperwork, never filled out income returns or filled it out the first year and that was that,” said Gina Rodriquez, Sacramento editor of Spidell’s California Taxletter.
On Dec. 30, the state tax board sent out the first of what it said would be monthly mailings that would attempt to reach the 23,332 limited liability companies its records show are eligible for suspension since the business structure became legal in California in 1994.
There were 484,945 California LLCs as of Dec. 1, according to the secretary of state’s office, which handles business entity registrations and cancellations. How many of those are still doing business is unclear, an issue the suspension program will help to address.
Next year, after the tax board’s program ends, the secretary of state’s office said it would begin suspension proceedings of its own. The office requires LLCs to file an information statement every two years or be subject to a $250 penalty. The Franchise Tax Board is responsible for collecting the penalty, along with the $800 annual tax and income-based fees.
The tax board said all LLCs targeted for possible suspension would be sent notification to their last known addresses, giving them 60 days to resolve the issue or clarify why the notice was in error before the suspension was imposed.
To avoid suspension, an LLC will have to file any missing income returns and pay back fees, taxes, penalties and interest charges.
Even if an LLC takes steps to legally cancel its registration, it will still owe returns and taxes, and possibly income fees, for each year it was in existence. Forms to cancel an LLC are online at the tax board website, at www.ftb.ca.gov.
“When you create a legal business entity, it’s going to take a legal document to unwind,” said Denise Azima, the tax board spokeswoman.
The board has said its suspension program will reduce the tax gap, as well as bring LLCs into compliance. The tax board said the LLCs owed $64.7 million in taxes, fees, penalties and interest. Yet it’s unclear what will happen if a non-operating LLC doesn’t respond or won’t or can’t pay taxes owed. If its owners, called “members,” walk away, are they personally liable?
“Can they come after me personally” as an LLC member, Rodriquez said. “That’s always been an issue.”
Because LLCs are a relatively new type of business entity, there are no court cases or laws that address the question, she said. At least one decision by the Board of Equalization has held that the tax board cannot hold a shareholder liable for corporate taxes if certain conditions are met, Rodriquez noted in a recent Taxletter article. She believes that the case may apply to an LLC member who walks away.
The appeal of the LLC entity has been that, like a corporation, it provides its members with limited legal liability.
Unlike a corporation, an LLC’s income passes through to individual members who pay tax on it at their personal tax rate, thus avoiding the double taxation that a corporation’s shareholders face. Corporate income is taxed at the corporate level as well as at the individual shareholder level.
For tax purposes, California classifies LLCs as partnerships, corporations or what it calls “disregarded” entities, which it treats as sole proprietorships. An LLC classified as a partnership or “disregarded” must pay an annual fee based on its income once it hits $250,000. The fee starts at $900 and rises to $11,900 for an LLC with income of $5 million or more. An LLC has to file an annual income return with the Franchise Tax Board.
LLCs classified as corporations for tax purposes are subject to state corporation taxes.
The constitutionality of the LLC fee has been challenged in court in three lawsuits, two of which are pending.
As part of the effort to close the budget gap, California officials have said they will bump up the due date for the fee on 2009 income to this year.
That means an LLC that estimates it will have enough income to trigger the fee -- at least $250,000 in 2009 -- will have to pay by June 15. A 10% penalty will be applied if the income comes in higher and the fee owed ends up higher. LLCs will still owe the income fee for 2008 on April 15, as well as the annual tax of $800.
LLC fees are estimated to reach $370 million in 2009.