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DISSOLVING A CORPORATION

DISSOLVING A CORPORATION

Many times business owners want to stop doing business together. This is what is typically called the “business divorce.” When you decide you want to close your business, you will need to do what is called “dissolving” and “winding up” your company. Dissolution is the process of officially ending the existence of the state-registered business entity, which will put it beyond the reach of creditors and claimants. A corporation can be dissolved either voluntarily or involuntarily. The dissolution process is governed by state law. This publication focuses on California law.

I. VOLUNTARY DISSOLUTION

Voluntary proceedings for winding up the corporation can be commenced upon the adoption of a resolution by the shareholders or the directors of the corporation or by written consent of the shareholders. In California, it is not specifically required that the board of directors take action before the shareholders vote. However, it is common that the board of directors will submit a proposal to the shareholders to dissolve the corporation and will then call a shareholders meeting to vote. The corporation’s Articles of Incorporation or Bylaws may designate the specific procedure for dissolution. Upon voluntary dissolution, the board will still act with the full powers to wind up and settle the affairs of the corporation. The “winding up” process allows the corporation to exist in order to take care of the final matters, which include: (1) paying all known corporation debts and liabilities; and then (2) distributing the remaining assets.

A. AUTHORITY TO VOLUNTARILY DISSOLVE CORPORATION

The shareholders holding at least 50% or more of the voting power must vote to voluntarily wind up and dissolve the corporation. The shareholder representing the requisite voting power can protect his investment by dissolving the corporation, so long as all alternative methods were exhausted, no unfair advantage is secured over the other shareholders, and no rights of third parties will be adversely affected. However, the right to dissolve the corporation is not absolute. Equity will not allow for dissolution to proceed in furtherance of defrauding the other shareholders, freeze out the minority shareholders, or to sell the corporate assets at an inadequate price. Moreover, shareholders who oppose the dissolution can force the 50% shareholder to sell his shares to the opposing shareholders. Also, particularly concerning corporations that are closely-held (that is, corporations that have less than 35 shareholders), shareholder approval consisting of 90% of the voting power must be given as to the terms of the sale of corporate assets in exchange for cash after dissolution proceedings have commenced when the buyer controls or is controlled by the seller.

In addition, in situations when the requiring shareholder approval of dissolution would serve no purpose, the board of directors is permitted to solely elect to dissolve. Such situations include: (1) when the corporation has been adjudged bankrupt; (2) when the corporation has disposed all of its assets and has not conducted business for five years; and (3) when the corporation has issued no shares.

B. PROCEDURE TO VOLUNTARILY DISSOLVE CORPORATION

In California, the voluntary dissolution of a corporation is initiated pursuant to California Corporations Code section 1900. A Certificate of Election to Wind Up and Dissolve must be filed with the Secretary of State. However, if a Certificate of Election is not filed, a corporation can be considered to be de facto wound up and dissolved.

C. POWERS OF DIRECTORS AND OFFICERS DURING VOLUNTARY DISSOLUTION PROCESS

Pursuant to California Corporations Code section 2001, the board of directors and officers, or other persons appointed by the Court when it has assumed jurisdiction over the dissolution process, have specific power and authority to perform acts for the corporation after the dissolution process has commenced. Such acts include: (1) electing officers and employing agents and attorneys to liquidate or wind up the corporation’s affairs; (2) performing contracts and settling debts and claims; (3) pursuing lawsuits in order to collect money or property owed to the corporation; and (4) selling or disposing of the assets of the corporation.

D. PETITION FOR COURT SUPERVISION OF VOLUNTARY DISSOLUTION

In order to protect the interests of any parties, the Court may take jurisdiction over the winding up upon petition of: (1) the corporation; (2) shareholder(s) holding at least 5% of the outstanding shares; (3) any shareholder of a close corporation; or (4) three or more creditors. To note, a close corporation consists of less than 35 shareholders. It is up to the discretion of the Court whether it will accept jurisdiction over the winding up process, and therefore the petitioner must allege the specific facts and actual controversy which warrants the Court’s supervision. Shareholders are not considered parties to the proceeding unless they are named as defendants from which the petition seeks relief or the shareholders intervene in the proceeding in order to protect their own interest.

E. CERTIFICATE OF DISSOLUTION

Once the corporation is completely wound up without Court proceedings, a majority of the board of directors must sign and verify a Certificate of Dissolution to be filed with the Secretary of State. This is also referred to as the “Articles of Dissolution.” Within the Certificate of Dissolution an affirmation is made that the final franchise tax return has been or will be filed for the corporation – this is considered to be “tax clearance.” Once the Certificate of Dissolution is filed, the corporation’s legal powers, rights, and privileges cease to exist. Moreover, the business name will be available for others to use after the corporation has been dissolved.

F. PETITION FOR ORDER DECLARING CORPORATION WOUND UP AND DISSOLVED

The board of directors may also file a petition in the name of the corporation with the Court for an order declaring the corporation to be completely wound up and dissolved. The Court will also require that notice of its order be served on all creditors, claimants, and shareholders so that they can show cause as to why an order should not be made declaring the corporation wound up and dissolved.

II. INVOLUNTARY DISSOLUTION

A verified complaint for involuntary dissolution of the corporation may be filed with the Court by: (1) one half or more of the board of directors; (2) shareholder(s) of not less than 33% of the outstanding shares; (3) shareholder of a close corporation; (4) any shareholder if the grounds for dissolution is the termination of the period of the corporation’s existence; or (5) any party expressly authorized in the Articles of Incorporation.

The proper grounds for an involuntary dissolution include: (1) the corporation has abandoned its business for more than a year; (2) the corporation is deadlock in that it has an even number of directors who are equally divided and therefore cannot adequately manage the corporation; (3) the corporation is deadlocked in that there are two or more dissenting factions of shareholders and therefore the corporation’s business cannot be conducted; (4) those in control of the corporation have committed fraud, mismanagement, or abuse of authority and therefore the corporation’s property is being wasted by its directors or officers; (5) liquidation of a close corporation is necessary to protect the interests of the shareholders; or (6) the period of the corporation’s existence has terminated.

A. INTERVENTION BY SHAREHOLDERS AND CREDITORS IN INVOLUNTARY DISSOLUTION ACTION

The term “intervention” refers to the procedure by which a third person, not the original party to the lawsuit, can claim an interest in the subject matter and become involved in the lawsuit in order to protect his right or interpose his claim. At any time prior to the trial of an action for involuntary dissolution, a shareholder or creditor may intervene. If a default judgment is obtained against the corporation in an action for involuntary dissolution, shareholders or creditors are not prohibited from intervening in order to assert their claims – the only effect of a default judgment is an acknowledgment that grounds exist to wind up and dissolve the corporation.

B. COURT APPOINTMENT OF PROVISIONAL DIRECTORS AND RECEIVER IN INVOLUNTARY DISSOLUTION ACTION

If the grounds for involuntary dissolution is due to a deadlock amongst the board of directors, the Court may appoint a provisional director to break the deadlock pursuant to California Corporations Code section 1800(b)(2). In doing so, the Court will attempt to avoid the dissolution of the corporation by breaking the deadlock.

In addition, if the Court believes that the interests of the corporation and its shareholders will suffer during the course of the dissolution process, the Court may order the appointment of a receiver to manage the business affairs and preserve the property of the corporation pending the dissolution action.

C. DUTIES OF DIRECTORS DURING INVOLUNTARY DISSOLUTION ACTION

Once an involuntary dissolution action has commenced, the board of directors must wind up the corporation affairs. The Court will supervise the winding up process and the Court may impose restrictions on the directors. The Court does not serve as a rubberstamp to the directors, and in fact the Court can revoke any actions taken by the directors. Moreover, the Court has the discretion to appoint a receiver.

D. POWER OF THE COURT

During the involuntary dissolution process, the Court has the general authority to make orders, decrees, and issue injunctions. In addition, the Court has the power to do the following: (1) require proof and make determinations concerning all claims against the corporation, including those claims that are contingent and unliquidated; (2) make determinations concerning the classification and rights of shareholders to the corporation’s assets; (3) oversee the accounting of the directors concerning the winding up process; and (4) remove and replace any director due to dishonesty, misconduct, negligence, or abuse of trust concerning the winding up process.

A certified copy of the Court’s decision must be filed with the Secretary of State once the corporation is completely dissolved by Court order, decree, or judgment.

III. CESSATION OF BUSINESS

Pursuant to California Corporations Code section 1805(c), once the dissolution process has commenced, the corporation must cease carrying on its business except to the extent necessary to wind up. During the winding up process, the corporation must close out the business bank account and cancel the business credit cards. However, it is advisable to wait a few weeks or months to close out the business checking account because it is likely that bills and unknown debts will need to be paid. An additional exception to the requirement to cease business exists during the time necessary for the corporation to preserve its goodwill and going-concern value pending the sale of its business assets.

Upon cessation of business, the corporation will no longer need the business ID number and it can therefore be cancelled. The corporation’s federal employer identification number can be deactivated by writing to the IRS. The EIN Assignment Notice should be included with the letter to the IRS. The state tax agency should be contacted in order to close the corporation’s state tax account. It is recommended that all tax documents be maintained for at least seven years after cessation of business.

IV. NOTICE OF DISSOLUTION

In addition, written notice of the dissolution action must be given by the directors to all known creditors and shareholders. Creditors generally include but are not limited to suppliers, lenders, service providers, and utilities. Providing adequate notice limits the time for which the creditor can bring a claim against the corporation. Moreover, in some jurisdictions, notice to creditors must also be published at least once a week for three consecutive weeks in a local newspaper within the county of the Court’s jurisdiction. If creditors and claimants do not present claims and proof within the Court’s designated time period, the claims may be barred and denied any distribution of the corporation’s assets.

V. STATUTORY BUY-OUT PURCHASE OF SHARES TO AVOID DISSOLUTION

California Corporations Code section 2000(a) creates a statutory buy-out right. The corporation, or the shareholders of 50% or more of the voting power, may avoid the dissolution and the Court’s appointment of a receiver by purchasing for cash the shares owned by the shareholders initiating the dissolution process. The purchase of the shares must be for the fair market value, which is determined by the current liquidation value. On application to the Court, the winding up and dissolution process may be stayed in order to ascertain the fair market value. The Court will appoint three disinterested appraisers to appraise the fair market value of the shares.

VI. PAY TAXES BEFORE DEBTS

The corporation’s first obligation is to discharge liabilities such as paying business taxes and all known creditors. It is highly advisable that the business owners retain the services of an accountant or a tax specialist.

A. FEDERAL TAXES ARE PRIORITY

First priority should be given to federal taxes withheld from employees’ paychecks, such as income tax withholding, social security, and Medicare taxes. If the business had employees, the final payroll tax and employment taxes must be filed timely. Both the state and federal tax authorities must be informed that the corporation is dissolving. The federal unemployment tax return (IRS Form 940 or 940EZ) and the employer’s federal tax return (IRS Form 941) must indicate that there will not be future tax returns filed. Also, the state withholding and wage reporting return must also indicate that there will not be future returns filed. The final wage and withholding information must be issued to employees on Form W-2 entitled Wage and Tax Statement by January 31 of the year after the business closes. The information must then be reported to the IRS using Form W-3 entitled Transmittal of Income and Tax Statements. If payroll taxes are not paid, the Internal Revenue Service can hold the shareholders personally liable and satisfy the obligation from their personal assets.

B. OFFER IN COMPROMISE OR INSTALLMENTS

If the corporation cannot pay its tax obligations to the Internal Revenue Service, the corporation may be able to pay less than what is owed by making an offer in compromise or negotiating to pay installments to the IRS. IRS Form 656 entitled Offer in Compromise should be filed with the IRS. IRS Form 433A entitled Collection Information Statement should be filed to obtain an installment payment plan.

C. INCOME TAX

In addition, state and federal income taxes must be filed. The corporation must file a final income tax return with the IRS and the state indicating that this is the final return to be filed. IRS Form 1120 entitled U.S. Corporation Income Tax Return should be filed indicating that it is the final return. Any income allocated to shareholders must be reported by filing IRS Form 1120S entitled Schedule K-1, Shareholder’s Share of Income, Credits, Deductions, etc. Shareholders will need to report a personal gain or loss on their personal tax return when returning the shares to the corporation. Lastly, the corporation will need to file IRS Form 966 entitled Corporate Dissolution or Liquidation. The forms need to be filed within two months and 15 days after the close of business.

D. OTHER DEBTS

After taxes are paid, the corporation’s other debts must then be paid, which may include unpaid rent, bank charges, money owed to suppliers, utilities, and other service providers. Such debts when paid in full or settled for a negotiated amount should be confirmed in writing. Only after debts and liabilities are satisfied, the corporation may then distribute remaining assets to shareholders.

VII. LIQUIDATION OF ASSETS

To note, the term “liquidate” means to settle the affairs of a business by selling assets, making collections of accounts receivable, and then applying the proceeds thus obtained to the payment of the business debts. Generally, business assets include but are not limited to equipment, furniture, vehicles, real estate, accounts receivable, customer lists, business name, copyrights, patents, and trademarks. In reality, it is not likely that the business assets can be sold for more than 80% of its current value. However, it is considered fraud if the assets are given away for free, sold at below market rates, or the directors and shareholders put their interests ahead of the business creditors.

If business assets are being sold, IRS Form 4797 entitled Sales of Business Property must be filed. If all the business assets are being sold as a group to one buyer, IRS Form 8594 entitled Asset Acquisition must be filed. After calculating the gain or loss on the sale, the total must be recorded on the business income tax return.

Moreover, if the buyer of the corporation’s assets is controlled or is under common control with the dissolving corporation, then the sale must be for cash and must be approved by at least 90% of the corporation’s voting power. For some assets that are difficult to sell, it is practical to donate the items to charity for a tax deductions. Only if there is any surplus after the debts are paid, the assets may be divided amongst the business owners.

A. BULK SALES

Pursuant California Commercial Code sections 6101 to 6111, which is referred to as the Bulk Sales Act, a bulk sale occurs when there is a transfer of the seller’s business of more than half the fair market value of the inventory and equipment. California’s Bulk Sales Act protects the business creditors by providing notice of a bulk sale and transfer. The purpose is to prevent the seller of a business from keeping the proceeds rather than paying the creditors. The California bulk sales law requires the purchase price of the business to be placed into an escrow account so that creditors can submit claims and be paid. The law requires that: (1) the buyer of the business must be provided the names and address used by the business for the past three years; and (2) the buyer must give notice of the bulk sale. The notice must consist of: (1) a statement identifying the sale of the business; (2) the date and location of the sale; (3) all business names and addresses used by the buyer and the seller for the past three years; (4) whether the sale is considered a small cash sale valued between $10,000.00 and $2,000,000.00; and (5) the description and location of the business assets being sold.

B. ASSETS SECURED AS COLLATERAL

For assets that are secured as collateral, the permission of the creditor is required before being sold. The sale of loan collateral is considered a fraudulent transfer and may be considered a criminal act. For property leases, the leased property in fact belongs to the lessor, and the proper procedure is to return the property to the landlord or assign the lease to another party which is generally subject to the landlord’s approval. The practical strategy is to negotiate with a secured creditor or lessor to settle for less than an amount that is owed on the loan or lease, and to have this confirmed in writing.

VIII. DISTRIBUTION OF ASSETS TO SHAREHOLDERS

After the corporation’s debts and liabilities have been satisfied, the board of directors must distribute the corporation’s remaining assets among the shareholders pro rata according to the respective rights and classification preference. In exchange, the shareholders return their outstanding shares to the corporation.

A. LIABILITY FOR DISTRIBUTING ASSETS BEFORE DEBTS SATISFIED

When the dissolution process is by Court proceeding or supervision, the Court will designate a period of time for claims against the corporation to be presented before any assets can be distributed. Directors of the corporation may incur civil and criminal liability for approving an improper distribution of assets before the corporation’s liabilities are satisfied. It is against state law for a corporation to distribute assets to the owners if the company cannot pay all of its debts. In addition, any shareholders who have received the improper distribution may also be liable. The creditor can sue for the return of the assets from the shareholders, and the directors and officers who approved the distribution can be held personally liable for the amount.

B. CONTINGENCY FUND

If it is at all possible that a creditor may present a claim after the corporation is dissolved, it is advisable to create a contingency fund to pay the debts owed to unknown creditors rather than to distribute the business assets to shareholders.

IX. OUT-OF-STATE BUSINESS

If the corporation has been registered to conduct business in other states, separate forms to terminate the corporation’s right to conduct business must also be filed within the respective states. The required form will vary by name, including Termination of Registration, Certificate of Termination of Existence, Application of Withdrawal, or Certificate of Surrender of Right to Transact Business. If the required forms are not filed with the respective Secretary of States, then the corporation will be liable to continue to pay annual fees and business taxes in those states.

X. BANKRUPTCY AND ASSIGNMENT

To get help liquidating the business assets, the corporation can file bankruptcy for the business, in which case the bankruptcy trustee will sell the business assets and pay off the creditors with the proceeds. If the corporation has significant debt and the creditors will not settle for less than what they are owed, bankruptcy may be the best and only option. The Court will sell the business assets and wipe out the remaining debt that cannot be paid. To note, a business bankruptcy will not affect an individual’s personal credit.

Generally, it is not necessary for an individual to file a personal Chapter 7 bankruptcy to avoid the business debts, as the corporate veil protects against personal liability. However, if a director or shareholder has personally guaranteed the debt or personally assumed the debt for the corporation, an individual personal bankruptcy may be required. The bankruptcy will be on the individual’s personal credit record for ten years.

Alternatively, the business assets and debts can be assigned to a third party company that specializes in business liquidation.

Justin Sterling, Esq. The Sterling Firm, A Professional Law Corporation www.TheSterlingFirm.com [email protected] (310) 498-2750

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