Maintaining an entity’s corporate privileges is essential to the wellness of any company or corporation. Moreover, forfeiting these privileges exposes the entity’s officers or directors to possible personal liability for debts of the entity incurred during the forfeiture period. To prevent this, an entity must timely file its annual franchise tax report and pay franchise taxes. Doing so will protect the entity’s officers or directors from the very liability the entity was formed to prevent.

Tax Code Chapter 171

Entity structures such as limited liability companies, partnerships,  and corporations protect the officers, directors, and partners of the entity by shielding them from personal liability for the entity’s debts and obligations. Part of maintaining an entity in the state of Texas involves the regular payment of the entity’s franchise taxes and filing its annual franchise tax report. Failing to timely pay the entity’s franchise taxes or submit the tax report can result in forfeiture of the entity’s corporate privileges. This then exposes the officers or directors to personal liability for any debts created or incurred post-forfeiture.

Chapter 171 of the Texas Tax Code dictates when an entity’s corporate privileges are forfeited. Although the chapter specifically references corporations, it also applies to limited liability companies and limited liability partnerships. Texas Tax Code § 171.0002; see Bruce v. Freeman Decorating Servs., Inc., No. 14-10-00611-CV, 2011 WL 358619 (Tex. App.—Houston [14th Dist.] Aug. 16, 2011, pet. denied) (mem. op.). Section 171.255 of the Texas Tax Code states that forfeiture of a corporation’s privileges due to “the failure to file a report or pay a tax penalty” will result in “each director or officer of the corporation [being] liable for each debt of the corporation that is created or incurred in this state after the date on which the report, tax, or penalty is due and before the corporate privileges are revived.” Section 171.255(b) holds the officer or director liable as if the officer or director was a general partner in a partnership.

One caveat to the officer or director being personally liable is she “must have actual or constructive knowledge of the wrongful acts giving rise to the ‘tax penalty’ incurred as an enforceable debt after forfeiture and must not have objected to those acts.” Hovel v. Batzri, 490 S.W.3d 132, 154 (Tex. App.—Houston [1st Dist.] 2016, pet. denied). Therefore, the officer or director is not liable for a debt if she did not have actual or constructive knowledge, or if she objected to the acts that caused the debt. Tex. Tax Code § 171.255(c)(1) – (2). However, this is sometimes a difficult exception  to meet. See Skrepnek v. Shearson Lehman Bros., Inc., 889 S.W.2d 578, 581-82 (Tex. App.—Houston [14th Dist.] 1994, no writ.) (“No evidence was presented that Skrepnek objected to the creation of the debt or that reasonable diligence would not have revealed the creation of the debt.”).

In addition to exposing officers or directors to personal liability for debts of the entity, failing to file the report or pay the franchise tax will preclude the entity from being able to bring and defend lawsuits in its name.

Creation of the Debt

The distinction of when a debt is “created or incurred” is important for determining when an officer or director is personally liable for the debts of the entity. Lower Texas courts are split on this distinction and the Texas Supreme Court has yet to make a decision on the issue. Most recently, however, the First Court of Appeals, in 2016, disagreed with the old definition in Cain v. State and held that a debt is “created or incurred when the events giving rise to the claim occurred.” Hovel, 490 S.W.3d at 134. The Hovels sued 7677 Real Property LLC, the company they engaged to construct their new home, alleging claims for breach of contract, violations of the Deceptive Trade Practices Act, and tort claims. Id. 7677’s corporate privileges were forfeited during the pendency of the Hovels’ lawsuit and the Hovels received a default judgment against 7677 during this forfeiture period. Id. Afterwards, the Hovels sued Gal Batzri, the single member and manager of 7677, seeking to hold Batzri personally liable for the judgment against 7677. Id. The Hovels argued that, “a debt does not come into existence until it is liquidated” and their damages became liquidated when they obtained the default judgment during 7677’s forfeiture period, thus holding Batzri personally liable to the Hovels. Id. at 136.

The court disagreed with the Hovels and held that the debt was “created or incurred” at the time they entered the contract and at the time the conduct underlying their claims occurred, all of which were pre-forfeiture. Id. at 145. In coming to its conclusion, the court implemented the “relation-back” doctrine, which “allow[s] future liquidated debts to relate back to the execution of the agreement through which damages were owed.” Id. at 139. The court reasoned that the Hovels’ claims, even the statutory and tort claims, stemmed from the construction contract between the parties, which was executed before 7677’s corporate privileges were forfeited. Id. at 145. As a result, the “debt was created or incurred when the acts … [giving rise] to the Hovels’ claims occurred,” all of which were pre-forfeiture events. Id. at 135, 145.

Forfeiture and Reinstatement

Before the comptroller forfeits the entity’s corporate privileges, the comptroller will notify the entity of its failure to file its franchise tax report and pay its taxes. The entity will then have an opportunity to rectify its mistake or risk forfeiture. The comptroller “shall forfeit the corporate privileges” if the corporation: (1) does not file its franchise tax report within 45 days after the date notice of forfeiture is mailed; (2) does not pay its franchise taxes within 45 days after the date notice of forfeiture is mailed, a tax is imposed by chapter 171 of the code, or does not pay the penalty imposed by chapter 171 relating to the tax within the prescribed 45 days; or (3) does not permit the comptroller to examine the corporation’s records as allowed by Section 171.211 of the code. Texas Tax Code § 171.251. If the comptroller has forfeited the entity’s corporate privileges, the Secretary of State will then forfeit the taxable entity’s charter or certificate, indicating on the entity’s file that its existence has been forfeited.

Do not ignore a notice from the Comptroller regarding a delinquent payment or filing. This is the entity’s chance to maintain its corporate privileges before potentially exposing its officers or directors to personal liability for the entity’s debts. Ignoring the Comptroller’s notice subjects the entity’s corporate privileges to forfeiture.

If an entity’s corporate privileges have been forfeited, all hope is not lost though. The corporate privileges may be revived. In that situation, you will need to file any outstanding tax reports and pay any outstanding taxes and penalties with the Comptroller in exchange for a “Not Tax Due” certificate and then reinstate the entity as soon as possible to limit the exposure of the officers or directors. The longer you wait to reinstate your entity status, the longer you expose the officers or directors to personal liability for debts of the entity. Note that while an entity may reinstate itself with the Texas Secretary of State, reinstatement does not retroactively protect directors or officers from debts incurred during the time of forfeiture. An officer or director is still potentially liable for any debts created or incurred during the forfeiture period before reinstatement.

Because this potential liability presents a trap for many businesses, it is important to either monitor this process diligently or make arrangements with your business lawyer to do so for your business.