Missing Annual Franchise Tax Reports Can Have Big Consequences

Gray Reed
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Gray Reed

A corporate client of the firm was recently sued for breach of contract and other violations. However, the company manager found himself facing a personal liability allegation for the company debts.  Why? The petition claimed that personal liability was warranted because the company failed to file a timely Texas franchise tax report.  This failure meant the company forfeited its corporate privileges from the day after the franchise tax report was due until the date when the report was filed and any associated tax liabilities were paid.  However, can this simple failure cause personal liability against the officers and directors for the debts of the corporation?

Texas Tax Code Section 171.251 requires the Texas Comptroller to forfeit the corporate privileges of a corporation on which the franchise tax is imposed if the corporation: (1) does not file a timely Texas franchise report within 45 days after the date notice of forfeiture is mailed; (2) does not pay the associated liabilities within 45 days after the date notice of forfeiture is mailed; or (3) denies the Comptroller access to the corporation’s records.  Texas Tax Code Section 171.2515 subjects all entities with limited liability protection in Texas to the forfeiture of corporate privileges even if they are not corporations.  Additionally, Texas Tax Code Section 171.255 exposes the directors and officers of a taxable entity to any debts of the entity that were “created” or “incurred” in Texas after the date on which the franchise tax report and associated tax liabilities were due until the corporate privileges are revived.

A director or officer can avoid personal liability for the debts of the entity if he or she can show that the debt was created or incurred: (1) over the individual’s objection or (2) without the individual’s knowledge and that the exercise of reasonable diligence to become acquainted with the affairs of the corporation would not have revealed the intention to create the debt.  Even after the entity’s corporate privileges are revived and the entity’s certificate of formation is reinstated, the personal liability of a director or officer for the period in which the corporate privileges were forfeited does not close.

Once the period of exposure is determined the extent of the financial exposure can then be assessed. If the company can pay the penalties and tax liabilities involved, then the company managers and officers might be exposed but not harmed. After resolving all of its outstanding tax matters with the Texas Comptroller, an Application for Reinstatement and Request to Set Aside Revocation or Forfeiture to reinstate the entity can be filed.

What about the alleged damages raised in the breach of contract dispute?

Texas case law identifies two lines of legal reasoning in determining when a debt is “created or “incurred”.  The first line of case law stands for the proposition that a debt is neither created nor incurred until it is reduced to a liquidated sum of money.

In Cain v. State, 882 S.W.2d 515 (Tex. App. – Austin 1994, no writ), Lee Cain appealed a district court decision holding him personally liable for the debts of the Timber Creek Oil Company of which he was an officer and director.

The Texas Railroad Commission had originally sued Timber Creek Oil Company and Mr. Cain, individually, to recover nearly $50,000 that it had spent plugging fifty of the company’s oil wells.  The commission authorized the expenditure of state funds on December 19, 1988, and paid out the funds between July 1989 and December 1989.  Timber Creek failed to file its 1989 Texas franchise tax report, which was due on March 15, 1989.  The issue before the district court was when the debt was created.  Mr. Cain relied on the relation back doctrine in arguing that the authorization created the debt and that he was not personally liable for the debt because it occurred prior to the entity’s forfeiture of corporate privileges.

The district court disagreed.  It found that the debt occurred after the forfeiture of corporate privileges when the commissioner made the payments.  The courts identified the authorization of the expenses as unliquidated damages and the payments as liquidated damages.  The appeals court affirmed Mr. Cain’s personal liability.

However, the appeals court in Hovel v. Batzri, 490 S.W.3d 132 (Tex. App. – Houston (1st Dist.) 2016) rejected the reasoning in Cain.  In Hovel, Robert and Tania Hovel appealed a district court decision that held that the sole manager of a limited liability company was not personally liable for the company’s debt to them.  The appeals court affirmed the district court’s ruling.

The Hovels has sued 7677 Real Property LLC for breach of contract and Deceptive Trade Practices Act violations related to the construction of their custom home.  While the case was pending, 7677 Real Property forfeited its corporate privileges and corporate charter under Texas Tax Code Section 171.255.  During the period of forfeiture, the Hovels were awarded lump-sum actual-damages of just over $2,000,000.  A few months after the default judgment, 7677 Real Property revived its corporate privileges and reinstated its corporate charter.

The appeals court in Hovel applied the relation back doctrine and held:

Using this construction of the phrase “created or incurred,” we hold that, under Section 171.255 of the [Texas] 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.  Because the Hovels’ claims relate to their contract with 7677, it is uncontested that the contract was executed pre-forfeiture, and the breach, tortious conduct, and injury occurred pre-forfeiture, we affirm.

There are 14 courts of appeals in Texas and two wildly different interpretations of the law.  The business owner is best advised to seek annual inoculation against personal liability by timely filing and paying its entity’s Texas franchise tax reports.  This inoculation has no adverse side-effects and is available to everyone.  Also, there are no wait lists as you can file right now through the Comptroller’s WebFile system (even though the 2021 Texas franchise tax filing deadline was extended to June 15 this year).

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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