Why You Need to Stay in Your State’s Good Graces

Law book and gavelCorporations and limited liability companies (LLCs) are creatures of state law. While entity choices may have federal tax law implications, it is state law that governs matters of setting up the entity, annual filings, and consequences for failure to comply with state law requirements. Organizing within a state confers powers, rights, and privileges, such as the right to do business there.

States usually require annual filings; these can be income taxes for corporations, an annual fee for LLCs and other pass-through entities, or other filing requirements. If you don’t do what’s required (file a return, pay taxes), the entity loses privileges in the state. For example, a corporation that fails to file a return (states may not suspend privileges before there are two or more non-filings) or owes taxes (again states may specific conditions under which this inaction triggers a suspension).

A suspension of corporate privileges prevents the corporation from taking certain actions such as:

  • Bringing an action or defending itself in court.
  • Receiving an automatic extension of time to a state income tax return.
  • Filing a claim for refund.
  • Filing or maintaining an appeal with the state revenue department.

Losing state privileges can also have federal tax ramifications. Take the following cases (one involving a weight loss company and another involving a law firm), both of which incorporated in California that didn’t pay their state income taxes.

Under California law, their corporate privileges were suspended for 90 days. (The California Franchise Tax Board issued a certificate of reviver and a certificate of relief from contract voidability after the suspension period was over). As a result, the corporation couldn’t file any lawsuits during this period. It happened that the corporations wanted to contest federal taxes in Tax Court but couldn’t do it. There is a 90-day period in which to file a petition in this court, but the 90-day period lapsed during the corporations’ suspensions.


Make sure you stay up to date with state law requirements. If you have problems, such as the inability of your corporation to pay state income taxes owed, address the problems head on (e.g., contact your state revenue department to work out a payment plan).

In some cases, the failure of a corporation to pay its debts, which includes taxes, can result in the owner holding the bag (even though an impetus for incorporating was to gain personal liability protection).

Best advice: always respond to any notice you receive from your state.


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