When corporate litigants skip out on taxes

We once again find ourselves in "tax season," the time of year when we sort through W-2s and 1099s and dig for proof of those charitable donations and business receipts. We do this in part because there are significant penalties to not paying state and federal taxes - including hefty fines, suspension of corporate status, and even prison time (think Leona Helmsley and Pete Rose). But can litigants - specifically corporate litigants - actually benefit from failing to pay their taxes? Sadly, the answer can sometimes be yes.

Under California Revenue and Taxation Code Section 23301, if a corporate entity fails to timely pay its taxes to the State of California, "the powers, rights and privileges of a domestic taxpayer may be suspended, and the exercise of the powers, rights and privileges of a foreign taxpayer in this state may be forfeited[.]" In other words, a California corporation may be suspended (or a foreign corporation forfeited) for failing to pay its state taxes. The same applies to LLCs, but for purposes of this article, we discuss only corporations.

The penalty under Revenue & Taxation Code Section 23301 is not punitive in nature, but rather is designed to pressure the corporation to pay its taxes. Nor is the penalty a new concept. In 1937, the Supreme Court of California explained, "the policy is clearly to prohibit the delinquent corporation from enjoying the ordinary privileges of a going concern, in order that some pressure will be brought to bear to force the payment of taxes." Boyle v. Lakeview Creamery Co., 9 Cal.2d 16, 19 (1937). After taxes are paid, the impact on the corporation is minimal - its status is reinstated and the prior delinquency shows on its record as an "irregularity" and nothing more.

What, then, is the impact of a suspended corporate status on litigation and counsel representing corporate litigants?

A suspended corporation is "disabled from participating in any litigation activities" and may not "resort to the courts for any purpose." Palm Valley Homeowners Ass'n, Inc. v. Design MTC, 85 Cal.App.4th 553, 560 (2000). A suspended corporation, in other words, can neither bring suit nor defend itself in any litigation, even in cases already pending.

Attorneys representing corporate litigants on both sides must be aware of their clients' corporate status. If a corporate litigant fails to file its taxes and is suspended at any time during the pendency of litigation, attorneys have a duty to advise the court of the suspension. Failing to advise the court would be a violation of the California Rules of Professional Conduct, including the Duty of Candor - which California courts have recognized since the 1800s. See Rule of Professional Conduct 3.3; see also In re Stephens, 77 Cal. 357, 359 (1888). The Court of Appeal in Palm Valley Homeowners Ass'n, Inc. v. Design MTC affirmed an order for sanctions against counsel who knowingly continued to defend a suspended corporate client, and affirmed further sanctions for discovery abuse because counsel had participated in discovery on behalf of the suspended corporate client. 85 Cal.App.4th at 563.

Must litigation grind to a halt when a corporation becomes suspended?

If a party cannot defend itself, and its attorney cannot ethically continue to represent the party, what happens to its pending cases? The authors have, unfortunately, seen the nonpayment of taxes and suspension of corporate status used as a strategy to delay litigation. Some courts are willing to issue continuances or stays to allow the pending reinstatement of corporate status. See, e.g., Timberline, Inc. v. Jaisinghani, 54 Cal.App.4th 1361, 1366 (1997).

The problem for a corporation's opposing party arises when (and has been the case in the authors' experience), the corporation can delay repayment/reinstatement until a time when resuming litigation is more favorable. Remember, while suspended, the corporation cannot even participate in discovery - while this means it cannot propound discovery, it also cannot respond to requests or produce documents. Effectively, the corporation uses its deliberate failure to pay taxes as a shield in litigation.

So what solutions exist for counsel on the other side of suspended corporations?

First, a continuance or stay is not automatic and can be opposed. Determining the corporation's diligence in reinstatement is key. In Old Fashion Farms v. Hamrick, 253 Cal.App.2d 233, 235 (1967), the Court of Appeal affirmed the trial court's denial of a continuance for a corporation to reinstate its status. The plaintiff corporation's status was suspended for four months before it brought its motion to continue, and the denial of a continuance was upheld in part because "there is no indication that plaintiff made any effort to seek revivor" during its four-month suspension. Id. at 236.

Additionally, if the suspended corporation is a defendant, its insurer may intervene so that the litigation can continue, per Revenue & Taxation Code Section 19719(b). An insurer may not defend the action on the insured's behalf, but may intervene to protect its own interests. Kaufman & Broad Communities, Inc. v. Performance Plastering, Inc., 136 Cal.App.4th 212 (2006). Such an intervention would allow litigation to continue to move forward while the corporate defendant resolves its suspended status. An insurer who does not intervene may additionally be barred from seeking fees and costs related to the action. Id. at 221-222.

Ben Franklin gave the adage that death and taxes are inevitable. We might also add litigation to that list.

Hannah K. Brown is a senior associate, and Gary A. Praglin is a partner at Cotchett, Pitre & McCarthy, LLP.