Factors need to be aware whether their clients are in good standing with the states where the clients conduct business. Most entities doing business in a particular state are required to pay state franchise taxes. Paying the taxes helps maintain an entity’s legal standing to do business in the state. Failure to pay, however, ultimately leads to tax forfeitures which can be a big problem for factors.
Tax forfeitures affect an entity’s liability protection. You are all familiar with the various entity forms. You know that some entity forms provide limited liability for owners, shareholders and partners. These include limited liability companies, S corporations, C corporations, limited liability partnerships, and professions corporations. You also know that sole proprietorships, general partnerships, joint ventures and DBAs have no limit on liability. Entities can lose their liability protection by failing to pay state franchise taxes.
Using Texas as an example, entities have three levels of standing. They are (1) “Good Standing,” (2) “Not in Good Standing,” (3) and ‘Temporary Good Standing.” Most states have the same or similar designations. “Good Standing” means the entity has filed all franchise tax reports and paid its franchise taxes in full. This allows the entity to continue doing business in the state. “Temporary Good Standing” is really no reflection on the entity itself. This simply means that the state has not yet processed the franchise tax reports. Until it does, all entities are granted temporary good standing.
“Not in Good Standing,” however, is very different. “Not in Good Standing” is a red flag for factors. It means that the entity has not paid its state franchise taxes and has, therefore, forfeited its right to do business in Texas. In practical terms, this means the entity is now operating as an assumed name or DBA so any shareholders, owners or partners are not protected personally from liability for debts incurred while the entity was “Not in Good Standing.” Or, to be more direct, you are now factoring a sole proprietorship or general partnership. My experience is that this not only can affect how you factor the client and perfect your security interest, but it is also a red flag that you may very well be factoring into a liquidation.
Because of the effect of failure to pay state franchise taxes, I recommend factors be vigilant in checking this. Usually, the state comptroller’s office will have this information. If you have a client whose account status changes for the worse, you should immediately contact the client to learn why this has happened and whether the client intends to correct the problem. This may allow you to catch a failing business early on and take appropriate steps to protect yourself. Or, it may allow you to avoid factoring a business that just wants your money while intending to file for bankruptcy protection. The bottom line is factoring a client who is not paying its state franchise taxes can be a recipe for disaster.
About the author:
Scot Pierce is a partner with the lawfirm of Bracket & Ellis, P.C. located in Fort Worth, Texas. He has represented a number of factors with commercial litigation and bankruptcy issues. He also regularly writes articles and presents speeches on creditor issues, including an upcoming teleconference on Issues to Consider when Litigating against Account Debtors. He can be reached at 817/339-2474 or spierce@belaw.com.