California corporations, limited liability companies, S-corps, and other types of business entities must pay annual taxes, called “franchise taxes” to the California Franchise Tax Board. The minimum amount owed is $800 each year, but this is just a minimum and higher franchise taxes may be assessed annually. Failure to pay corporate franchise taxes will result in the business entity being suspended, which will result in the business entity losing legal rights such as the ability to enforce contracts and the ability to sue or defend a lawsuit while taxes remain unpaid. See Cal. Rev & Tax Code § 23301.

As a simple example, if your corporation manufactures and supplies cellular phone components and signs a supply contract to deliver 100,000 components for $100,000, you will not be able to sue the customer for non-payment if you let your company’s legal status be suspended by failing to pay your taxes. This can cause a financial catch-22, of course, since you may need to get paid in order to pay your taxes, but you have to pay your taxes to be able to sue to get paid. Unfortunately, this is one of the risks of being in business. Pay your taxes.

The tax payment issue is important with respect to mergers and acquisitions, assignment of rights, and insurance subrogation. In general, the person or entity accepting an assignment or subrogation steps into the shoes, as the saying goes, of the entity giving the assignment or subrogation. If the assignor or subrogor has failed to pay its franchise taxes (or is otherwise not in good standing), then the assignment/subrogation fails. If the assignor/subrogor cannot exercise legal rights, neither can the entity receiving the assignment or subrogation.

This was the result of the recent case of Travelers Property Casualty Company of Am. v. Engel Insulation, Inc., 29 Cal. App. 5th 830 (Nov 30, 2018). In that case, several insurance companies defended cases filed and otherwise paid out claims for a corporate insured. The case involved a suit against a limited liability company called Westlake Villas, LLC, (the insured) by a California homeowners association. The claim related to various construction defects, breaches of contract, and breaches of warranty. As is common, Westlake had many subcontractors and had subcontracting agreements with them. Among the subcontractors was Engel Insulation. The subcontracting agreements had indemnity and hold harmless provisions whereby subcontractors like Engel were obligated to pay for the legal fees and judgments that might be suffered by Westlake. At some point, Travelers, as Westlake’s subrogee, sued Engel (and other subcontractors). But by the time Travelers filed suit, Westlake’s corporate existence as an LLC had been suspended for failure to pay its franchise taxes.

Engel sought dismissal, claiming that since Westlake could not sue, neither could Travelers. The trial court agreed, holding that under California law, a subrogating insurance company has no rights greater than the rights of their insureds. Since the underlying insured — Westlake — had been suspended and, by being suspended, could not sue on the indemnity/hold harmless provision, then Travelers was also barred from suing. The Third District Court of Appeals of California affirmed.

Contact San Diego Corporate Law Today

For more information, call experienced business attorney Michael Leonard, Esq., of San Diego Corporate Law. Call Mr. Leonard at (858) 483-9200 or contact him via email. Mr. Leonard has been named a “Rising Star” four years running by SuperLawyers.com and “Best of the Bar” by the San Diego Business Journal. Mr. Leonard’s law practice is focused on business, transactional, and corporate matters and he proudly provide legal services to business owners in San Diego and the surrounding communities.

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