The past two years have been dominated by the COVID-19 pandemic in multiple ways.  While we have so far avoided a significant economic downturn, some businesses have been severely challenged by new regulatory requirements and shifting consumer patterns.

As 2021 draws to a close, you may have reached the conclusion that your business prospects for 2022 will not meet your expectations, financially or otherwise.  Closing your business can be a difficult choice to make, and businesses dissolve for a variety of reasons, and not all of them are necessarily negative.  Properly dissolving the business will ensure that when you do start anew, it will be with a clean slate.

What is Dissolution?

Dissolution is a legal process that terminates a business's existence. If a business is not properly dissolved, it continues to exist as a legal entity under state law. This means that it will be remain subject to corporation or LLC filing requirements, including with state and federal agencies such as the secretary of state, franchise tax board, internal revenue service, in addition to state and local filing requirements such as licensing and permits.

Simply "ceasing operations" and failing to meet these continuing obligations can result in fines, taxes, penalties and potential personal liability for those obligations. Dissolution is a multi-step process involving the filing of dissolution documents with the various local, state, and federal agencies, in addition to internal paperwork with respect to the businesses' other owners and the businesses' creditors.

Step 1 – Ownership Approval

A corporate or LLC dissolution generally requires that the shareholders or members approve the dissolution. Typically corporate bylaws or the LLC's operating agreement spells out the process for dissolving, including shareholder and member approvals needed, and the manner and method by which to notice any meetings of the shareholders, board of directors and/or members to accomplish this first step. Unanimity is not always required. For instance, California Corporation Code §1900 provides that a corporation may elect to wind up and dissolve voluntarily on the vote of at least 50% of the outstanding shares.

Step 2 – Prepare Dissolution Documents and Give Notice

Once the dissolution has been approved, either unanimously or otherwise, the requisite forms need to be filed with the California Secretary of State and any other state where your corporation or LLC is qualified to transact business. In California, if the election to dissolve is made by the vote of all the outstanding shares then the Certificate of Election To Wind Up and Dissolve does not have to be led with the Secretary of State, but a statement that the election to dissolve was made by a vote of all the outstanding shares must be included in the Certificate of Dissolution that is filed with the Secretary of State.

If at least 50% but less than all of the outstanding shares elect to dissolve than the corporation must file the Certificate of Election to Wind Up and Dissolve form (Form ELEC STK) with the Secretary of State either prior to, or simultaneously with, the Certificate of Dissolution form (Form DISS STK).

If there are dissenting shareholders or members, the board of directors of the corporation (or managing member of the LLC) must mail written notice of the commencement of the voluntary dissolution to all shareholders except those who voted in favor of dissolution and to all known creditors and claimants who appear on the records of the corporation.

A word of caution – If you applied for and have received funds from the Small Business Administration's Economic Injury Disaster Loan program, it is imperative that you review the loan agreements including promissory notes and any personal guarantees, as this may ultimately affect your decision in how to proceed with, if at all, dissolution of your business entity. Unlike the Payment Protection Program Loans which have a forgiveness element, if you applied for and received any EIDL Loans, you may have signed a personal guarantee and backed the loan by business collateral including tangible and intangible property like inventory and equipment. Typically, for EIDL loans that exceeded $25,000.00, borrowers' restrictions include the inability to sell, lease, license, transfer collateral, or cease operations without prior approval from the SBA. Failure to seek the proper approvals may trigger a default and acceleration clause, causing the entirety of the loan balance to become immediately payable and due. 

Step 3 – Permit Cancellations

An often overlooked piece of the dissolution process is the cancellation of licenses and permits held by the business. Because licenses and permits are issued at the federal level as well as multiple state and local government levels, numerous cancellations may be required depending on your business's industry and where you transact business.

Step 4 – Tax Filings

Dissolution of a corporation requires the preparation of both State and Federal tax filings and as well as possible filings and payments including sales tax, employment taxes and any applicable local (county and/or city taxes). You should discuss what filings need to be completed with your accounting.

Dissolution & Personal Liability

Corporations Code §§316(a), 2004 and 2005(a) provides that it is the responsibility of the directors or others appointed to wind up to determine that the corporation's debts and liabilities have either been paid or adequately provided for before the distribution of assets to shareholders. Directors and shareholders may be held personally liable for unpaid corporate debts if corporate assets are distributed to the shareholders without payment or adequate provision for payment of corporate liabilities.

Additionally, it is important to analyze any potential disputes and prospects of civil lawsuits, as they may be filed and served against a dissolved corporation whether the cause of action arose before or after dissolution (California Code of Civil Procedure section 416.20; Corporations Code section 2011(a)(1).)  Shareholders may be liable for claims against a dissolved corporation whether arising before or after dissolution. However, there are certain limits placed on shareholder liability with respect to (1) the amount recoverable and also, (2) the duration of liability. (California Corp. Code section 2011(a)(1)(B); Favila v. Katten Muchin Rosenman LLP (2010) 188 Cal.App.4th 189, 213).

Typically, Shareholders' post-dissolution liability is limited to the total amount of assets distributed to the shareholder or their pro rata share of the claim – whichever is less. There are also certain time restrictions on when claims can be brought against a shareholder of a dissolved corporation, typically either (a) the expiration of the applicable statute of limitations on the specific cause of action alleged or (b) four years after the dissolution of the corporation.

There is a tendency when it is time to close down a business to take short-cuts simply to "get it over with." While this is certainly understandable, considerations such as personal liability for business debts and tax consequences should prompt you to treat the process of ceasing operations and dissolving your business with the same attention to detail as that used to begin the entity. If done correctly, it is a relatively simple and quick process. If ignored, it can come back to haunt you when you least expect it, in retirement or after starting a new business.

Originally Published 08 November 2021

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.