04 May Losing Your Corporate Shield – What Every Director and Officer of a Texas Entity Needs To Know
Entity structures such as corporations, limited liability partnerships, and limited liability companies protect officers, directors, and partners by limiting their personal liability for the entity’s debts and obligations. To preserve these privileges, an entity must comply with certain rules and regulations. It is important that the corporation reports its franchise taxes annually and pays them promptly to maintain its corporate privilege. If the officers and directors do not comply with these requirements, they become personally liable for the expenses incurred by the entity.
Tax Code Chapter 171
Chapter 171 of the Texas Tax Code dictates when an entity’s corporate privileges are forfeited. Although the chapter specifically refers to corporations, it also applies to limited liability companies and limited liability partnerships. Tex. Tax Code § 171.0002. If the corporate privileges are forfeited, each director or officer of the corporation becomes liable for each debt of the corporation that arises after the date when the report, tax, or penalty was due and before the corporate privileges were restored.
The officer or director will be held liable as if he or she was a general partner in a partnership unless they had no actual or constructive knowledge of the wrongful acts that led to the “tax penalty” and did not object to those acts. Hovel v. Batzri, 490 S.W.3d 132, 154 (Tex. App.—Houston [1st Dist.] 2016, pet. denied). However, this is often a difficult exception to meet. 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 the entity’s debts, failing to file a report or pay the franchise tax can prevent the entity from being able to bring and defend lawsuits in its name. Tex. Tax Code § 171.252. Following this rule, plaintiffs may seek default judgments against forfeited entity defendants, however, many times courts have held that despite the clear language of the statute, a forfeited entity can defend itself in a lawsuit – it just cannot bring the lawsuit. See Mello v. A.M.F. Inc., 7 S.W.3d 329, 331 (Tex. App.—Beaumont 1999, pet. denied) (stating that, despite clear language of section 171.252, “the statute has historically been limited to prohibit defendants from bringing cross actions, not from merely defending lawsuits”).
Creation of the Debt
Determining when an officer or director is personally liable for an entity’s debts hinges on when the debt was “created or incurred.” Lower Texas courts are divided on this issue, and the Supreme Court has yet to decide on the issue. The First Court of Appeals has held that a debt is “created or incurred when the events giving rise to the claim occurred.” Hovel, 490 S.W.3d at 134.
In Hovel, plaintiffs 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. While the lawsuit was pending, Real Property’s corporate privileges were forfeited, allowing the plaintiffs to take a default judgment against Real Property. The plaintiffs then sued Gal Batzri, the single member of the entity, seeking to hold him personally liable for the judgment the plaintiffs received against Real Property. The court, however, held that the “relation-back” doctrine made it so that Real Property’s debt was created or incurred at the time the parties entered into their contract and at the time the conduct underlying the plaintiffs’ claims occurred, i.e., when the faulty construction occurred. The court held that because the acts that gave rise to the plaintiffs’ lawsuit occurred before Real Property’s corporate privileges were forfeited, Batzri could not be held personally liable for the entity’s debts. Id.
Forfeiture and Reinstatement
It is important for entities to promptly respond to any notice from the Comptroller regarding delinquent payments or filings to avoid forfeiture status. Before an entity is forfeited, it will have the opportunity to rectify its mistake. However, if the entity does not respond, 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. Once 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.
If forfeiture occurs, the entity can still be reinstated by filing any outstanding tax reports and paying any outstanding taxes and penalties with the Comptroller. The entity will then need to apply for reinstatement with the secretary of state. Note that while the entity may be reinstated, officers or directors may still be liable for any debts incurred during the period of forfeiture before reinstatement. It is recommended to monitor this process diligently and seek assistance from a business lawyer to avoid potential traps and liabilities.
ABOUT THE AUTHOR: Kelly Christy is an Associate at Rapp & Krock, PC.
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