Pre-Revenue Companies Must Pay Taxes and File Tax Returns
The biggest myth about incorporating in the startup community is that if the company has no revenue, there is no obligation to file tax returns or pay franchise taxes. This is wrong, and this article, we will debunk that myth.
In our last article, we noted California corporations must pay a minimum franchise tax of $800 every year after their first taxable year.[1] New business owners might think they do not have to pay the tax if the business does not have any revenue. They would be wrong. The California State Board of Equalization has repeatedly ruled that “[p]ayment of the minimum franchise tax is not contingent upon the corporation conducting any business or engaging in profitable activities; rather, the tax is imposed for the privilege of exercising the corporate franchise within this state. A corporation is still liable for the minimum franchise tax even when it does not conduct any business or have any income upon which to measure the franchise tax.”[2] In other words, after your first taxable year, you have to pay at least $800 a year just for the privilege of having a corporation formed or qualified to do business in California, whether or not you actually do any business there during the year.
Do Not Forget California Minimum Franchise Taxes
If you make the mistake of not paying at least the minimum tax in a year, then you may also be responsible for paying various penalties. California law provides for a late filing penalty of five percent of the total unpaid tax, plus 0.5 percent per month of the “remaining tax,” with a cap of 25 percent of the total unpaid tax.[3] The penalty may be abated if the taxpayer can show that the failure to make a timely payment of tax was due to reasonable cause and not due to willful neglect.[4] To establish “reasonable cause” for late payment of tax, the taxpayer bears the burden of showing that its failure to make a timely payment of the proper amount of tax occurred despite the exercise of ordinary business care and prudence.[5] It is not enough to show reasonable cause that the taxpayer simply misunderstood its liability to pay the minimum annual franchise tax even if the company had no revenues.[6]
The same mistake will also subject you to a penalty for the underpayment of estimated tax. A corporation subject to the income or minimum franchise tax must file a declaration of estimated tax and pay the estimated tax for each year.[7] If the corporation estimates having to pay only the minimum franchise tax, then the entire amount of the estimated tax ($800) is due and payable on or before the 15th day of the fourth month of the taxable year.[8] If you failed to pay the estimated tax when due (which you obviously did since you didn’t realize you had to pay any tax at all for the year), then your corporation must also pay a penalty for the underpayment of estimated tax.[9] Unlike the late filing penalty, there is no exception for reasonable cause or extenuating circumstances to the underpayment of estimated tax penalty (not that you’d qualify for any such exception anyway under the circumstances we’re discussing).[10] In the Md. Biotech Corp. case, the addition of the two penalties, plus interest, increased the taxpayer’s bill by $127.34, or about 15 percent more than the $800 minimum franchise tax that the corporation mistakenly failed to pay.
And Do Not Mess With The IRS
The penalties can get significantly steeper if the taxpayer is an S corporation. In California, for example, in addition to all of the other penalties (plus interest) noted above, an S corporation that files a late return is also subject to a penalty of $18 for each month the return is late (not to exceed 12 months) for each person who was a shareholder in the S corporation during any part of the taxable year.[11] That is chicken feed compared to the penalty for filing a late federal S Corporation return on Form 1120S, which is $195 per shareholder for each month the return is late (up to 12 months).[12] So, for example, if you have a two-person S corporation and fail to file your federal return for a year because you mistakenly thought you weren’t required to file because you had no revenue, you are looking at a federal S corporation late filing penalty of $4,680 ($195 x 2 shareholders x 12 months).[13]
The penalties for late filing can lead to some eye-opening results. In one California tax case, the appellant (Penoe) was an S corporation incorporated and domiciled in California. Penoe had no business activity after December 31, 2009, and closed its business on December 31, 2010. However, Penoe did not send a dissolution request to the California Secretary of State’s office until January 2011. Unfortunately, the certificate misspelled the name of the company (“Peone” instead of “Penoe”) and the dissolution therefore did not go through. Penoe did not notice that the dissolution had not yet occurred until the end of 2011, and sent in a second dissolution request in January 2012. In January 2013, Penoe filed late California tax returns for 2010 and 2011. Because a corporation does not escape liability for the minimum franchise tax in California until after the taxable year in which it was dissolved,[14] the Franchise Tax Board concluded that Penoe was responsible for the payment of tax and penalties as follows: (1) for 2010, the minimum franchise tax of $800, a late filing penalty of $200, an S corporation late filing penalty of $864, an estimated tax penalty of $29.28, plus interest of $69.12, for a total of $1,962.40; and (2) for 2011, the minimum franchise tax of $800, a late filing penalty of $200, an S corporation late filing penalty of $720, an estimated tax penalty of $25.32, plus interest of $32.62, for a total $1,777.94.[15] On appeal, the Franchise Tax Board agreed to abate the late filing penalty and S corporation late filing penalty for 2011, but its decision was otherwise sustained in its entirety by the California State Board of Equalization.[16] Luckily for Penoe, the IRS waived the federal S corporation late filing penalties for reasonable cause,[17] but the company was still stuck paying a substantial tax bill simply because it transposed two letters on its original certificate of dissolution filed with the California Secretary of State’s office.
The moral of the story is that forming a corporation before you need to can become a costly mistake. Before you jump online, speak with your CPA about the ongoing obligations to pay taxes and file tax returns. This is the reason why we do not form companies for clients who do not have accountants on their teams. See, Why eMinutes Requires Clients to Have CPAs.
[1] See Cal. Rev. & Tax. Code § 23151(a), 23151.1(e), 23153(a), (d)(1), (f).
[2] In re Appeal of Penoe, Inc., No. 785013, 2014 WL 10061056, at *3 (Cal. St. Bd. Eq. Oct. 14, 2014) (citing Appeal of Vitmora Co., No. 78-SBE-079, 1978 WL 3552 (Cal. St. Bd. Eq. Sept. 27, 1978), and Appeal of Mission Valley E., No. 74-SBE-039, 1974 WL 2855 (Cal. St. Bd. Eq. Oct. 7, 1974)).
[3] See Cal. Rev. & Tax Code § 19132(a).
[4] Id.; In re Appeal of Md Biotech Corp., No. 398016, 2009 WL 532507, at *3 (Cal. St. Bd. Eq. Jan. 21, 2009).
[5] Md Biotech Corp., 2009 WL 432507, at *3.
[6] Id.; see also Penoe, 2014 WL 10061056, at *5 (“[I]gnorance of the tax law is not reasonable cause to abate the penalty.”).
[7] See Cal. Rev. & Tax Code §§ 19023, 19025.
[9] See Cal. Rev. & Tax Code §§ 19142, 19144; Md Biotech Corp., 2009 WL 432507, at *3 (“[A] corporate taxpayer is subject to the underpayment of estimated tax penalty when it fails to make any payments of estimated tax until after the end of its fiscal year.”)
[10] See Penoe, 2014 WL 10061056, at *6; Md Biotech Corp., 2009 WL 432507, at *3.
[11] See Cal. Rev. & Tax Code § 19172.5. The S corporation late filing penalty is subject to a “reasonable cause” exception, id. § 19172.5(a), but as we’ve seen the exception is of no value where the taxpayer failed to file simply because it was ignorant of the legal obligation to file.
[12] See 26 U.S.C. § 6699. The federal S corporation late filing penalty is subject to a “reasonable cause” exception. See id. § 6699(a). As in California, the exercise of ordinary business care and prudence may constitute reasonable cause. See Babak Roshdieh, M.D. Corp., T.C. Summ. Op. 2014-113, 2014 WL 7373354, at *4 (T.C. Dec. 29, 2014).
[13] See Babak Roshdieh, M.D. Corp., 2014 WL 7373354, at *2 (one-shareholder S corporation that filed 11 months late subject to federal late filing penalty of $2,145 ($195 x 1 shareholder x 11 months)).
[14] See Cal. Rev. & Tax Code § 23151.2 (“In any event, the tax for the taxable year of its dissolution or withdrawal shall not be less than the minimum [franchise] tax provided for in Section 23153 for that taxable year”).
[15] See Penoe, 2014 WL 10061056, at *1 & nn. 1, 2.
[16] Id. at *6.
[17] See id. at *2.