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.

Last November, a bankruptcy judge in the Northern District of Texas issued an opinion in Danny and Kimberly McClure v. Bank of America, Creditors Financial Group LLC and Peter Rebelo, 2009 WL 4263365, (N.D. Tex. 2009) that reminds us of the consequences of violating the discharge injunction.  Danny and Kimberly McClure filed for bankruptcy protection in July 18, 2007 and received a discharge on November 15, 2007.  Among the debts discharged were personal guaranties on two Bank of America credit cards in the names of their business.

After the couple’s debts had been discharged, Bank of America referred the credit card debts to a collection agency.  Bank of America testified that they knew the debtors had filed for bankruptcy when they referred the case to the collection agency.  As an aside, this is not the kind of testimony that you want to have.  Bank of America essentially admitted that they willfully and intentionally violated the discharge injunction.

When the collection agency received the placements, they performed an initial bankruptcy scrub, but used the tax identification number from the business that Mr. McClure owned instead of Mr. McClure’s social security number to run the scrub.  Because of this, they failed to learn of the bankruptcy discharge.

The collection agency then assigned each credit card to a different collector.  The first collector performed an Accurint search and found Mr. McClure’s social security number.  In spite of this, he did not perform another bankruptcy scrub.  That collector then contacted the McClures for payment.  Mr. McClure testified that the collector told him that someone was likely headed to his house and that the collection agency would be filing a lawsuit shortly if he did not pay.  The very fact that the court mentioned this testimony in the opinion indicates that the court was disturbed by the collector’s tactics.  At that time, Mr. McClure informed the collector that he had received a bankruptcy discharge.

The first collector then entered the bankruptcy information into the collection agency’s system and apparently ceased his collection efforts.  But the second collector, who was assigned to collect the debt owed on the other credit card, did not have access to this same information so he sent a collection letter and attempted to contact the McClures for payment.

That triggered the debtors filing a motion for contempt for willfully and intentionally violating the discharge injunction.  The debtor requested attorney fees, damages and sanctions against Bank of America, the collection agency and the second collector.

After hearing the evidence presented, the court denied recovery and sanctions against the second collector.  The court, however, did find that both Bank of America and the collection agency willfully and intentionally violated the discharge injunction.

The court awarded the debtor $79,839.14 in attorney fees and $2,500 in actual damages both jointly payable by Bank of America and the collection agency.  The court also awarded a separate $100,000 sanction against Bank of America and $50,000 sanction against the collection agency.  Each party’s sanction would be suspended and need not be paid if the president or  general counsel of each company submitted an affidavit within 90 days detailing how their procedures had been changed to prevent this from happening again in the future.

A number of lessons can be learned.  Among them is to ensure that you have adequate procedures in place to protect against violating the discharge injunction or automatic stay.   Also, be careful who you refer delinquent accounts to for collection.  I believe there is at least a possibility that Bank of America would never have been sanctioned if the collection agency had not had faulty procedures that triggered the debtor to complain to the bankruptcy court.  I also believe the strong arm tactics that the collection agency used made the situation worse.  The bottom line is you should check your procedures to ensure that once your company becomes aware that a debtor is in bankruptcy or has a received a discharge–stop collection efforts immediately.

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.  He can be reached at 817/339-2474 or spierce@belaw.com.