Why You Should Close Your Dormant Entity
Did you know that a corporation or LLC is considered to be a legal “person” under the law? An existing entity established under state law is like a living human being—it has legal rights, tax obligations, and it can be sued. Until it is “pronounced dead” so to speak, by terminating it under state law, it remains alive and will be exposed to potential creditors, tax obligations, and other compliance responsibilities. When an entity exists under state law but is not actively engaging in a trade or business, it is called a dormant entity.
How Do Entities Become Dormant?
One great aspect of small business owners is that they are entrepreneurial in nature. Many small business owners are filled with potential ideas for a new venture, or several of them, and they do not hesitate to put those ideas into action. While ingenuity plus action has created some of the greatest companies in American history, what happens more often is that the founder creates the company, and it sits dormant, or never gets to the point where it begins to produce revenue. It can be a very emotional decision for the founder to cut his losses and close the entity. So, rather than face that tough decision, he lets the entity sit because—who knows—he may use it again someday. There are several good reasons not to let the entity sit dormant. If there is no clear plan to use the entity again, the best course of action is to wind it up and terminate it under state law.
What Are Some Impacts of Having a Dormant Entity?
The impacts of having a dormant small business entity can range from the annoying to the substantial. Generally, the impacts will be based on how far the business made it into its life cycle before it became dormant. Here are some examples of the impact that having a dormant entity can have on its founder when the business has reached the infancy stage, the growth stage, and the mature stage.
When a founder incorporates an LLC or corporation under state law, there will generally be a fee to form the entity that ranges from $200 – $400. The founder may think that this will be the extent of her loss if she decides not to pursue the business further. However, that is only the tip of the iceberg.
Most states charge an annual fee to keep the entity in good standing. The fee generally ranges from $200 – $400 per year. Some states call this requirement an “annual report” filing requirement, and penalties are imposed for late filings. I have seen several instances where a founder forgot about the entity’s existence, and the fees and penalties eventually ballooned into the thousands of dollars. Depending on the state, sometimes the Secretary of State will administratively dissolve your entity without you knowing, or it may assess the aforementioned annual fees routinely for several years and refuse to allow you to wind up your entity until you have paid the account in full. This is a very unfortunate result for a business that never got off the ground.
Also, keep in mind that depending on the tax classification, there can also be a filing requirement for the entity even if there is no activity (i.e., for a C or S Corporation). The taxing authorities oftentimes send notices which may cost time and money to resolve. Additionally, there may be a minimum franchise tax on the state level simply for existing in that state (even in the absence of revenue). Failure to file the returns and pay their associated taxes can result in significant costs down the road, depending on the amount of the minimum franchise tax assessed in that state.
So, even if an entity never makes it out of the infancy stage, keeping the entity dormant rather than terminating it can result in thousands of dollars of costs and hours of lost time dealing with taxing authorities. And we all know that time is money!
The growth stage can be described in different ways by different people. In the case of a small business, I am referring to the growth stage indicating that efforts were made to operate the business after its formation. This includes opening bank accounts and credit cards, obtaining a line of credit, making investments in software, obtaining an office space or virtual office, investing in monthly subscriptions (such as for maintaining books), and potentially hiring an employee or two.
A business that becomes dormant in this stage oftentimes does so because of failure to plan before the business launches. Maybe there was not significant startup capital to cover expenses prior to generating revenue or the business was too reliant on a single customer or client. But sometimes the business could become dormant due to circumstances beyond the owner’s control. COVID-19 and its related shutdowns could have an impact on a business’s ability to continue, the owner could have unexpected health or family issues that prevent him from continuing operations, or any number of other unexpected scenarios can happen that change the trajectory of the business. Whatever the case, the costs of a dormant entity that reached the growth stage can be substantial.
Even for the smallest of businesses, many fixed costs are incurred monthly and can range from hundreds to thousands of dollars per month, even if no revenue is earned in that month. The many costs small business owners pay which accumulate to large sums are oftentimes referred to as “death by a thousand cuts”. Leaving the business dormant rather than closing it, when the business makes it to this stage can be very expensive. Also, consider all the costs mentioned in the “Infancy” section and add those on—as they apply too.
In the context of a small business that reaches the mature stage, it is rare that an entity would reach this level and fail to properly wind up. This is because these entities typically reach the point of having a team of professionals on-call to assist them with anything they need. They tend to have a dedicated CPA (or firm of CPAs) or a dedicated Attorney (or even several firms that specialize in different areas of law). When I speak of a business in the mature phase, I am referring to a business that at some point has been profitable for a substantial period of years. It may have even added one or more locations over time or merged with other entities.
But I can think of a former client whose business became dormant that had reached this stage. The client owned four tanning salons in different locations in her city, but competition with other businesses, employee turnover, and other difficulties resulted in the gradual reduction of locations. Eventually, she found a buyer willing to purchase all assets of the remaining salon in an asset sale. Selling the assets was great, of course, as it put money in the founder’s pocket and enabled her to walk away. But selling the assets did not rid her of the obligations to file taxes and annual reports, pay for monthly subscriptions, and meet the other obligations of an existing business. The sale had already happened when I engaged with the client, and I was tasked with filing final returns reflecting the sale. It was astounding to see the costs that continued to flow through the bank, even a year after the sale, due to failure to cancel some of the auto-draft subscriptions, monthly bank fees, etc. What potentially could have been a profitable sale (had the entity winded up immediately after the assets were sold) resulted in a break-even transaction due to failure to properly terminate the entity under state law. And there was also the argument that these post-operation expenses may not be deductible given that they are not both “ordinary” and “necessary” for a business that no longer operates.
A significant concern that applies to mature entities that become dormant is the risk of lawsuits from potential plaintiffs and creditors. A disgruntled employee from five years ago may sue, or a creditor may come out of the woodwork that had not been actively collecting the debt. The risks, as well as the costs, can be astronomical for a business that has reached the mature stage to remain dormant.
Can A Dormant Entity Be Prevented?
The best way to prevent an entity from becoming dormant is to avoid forming an entity under state law unless you are sure it is something you want to pursue AND you have a plan for pursuing it and making it profitable. Just having a business idea does not warrant the need to establish an LLC for that idea. If something is just an interest, there is nothing wrong with having an unincorporated sole proprietorship for a month or two, which will allow you sufficient time to see whether it might be worth investing further time and effort into the endeavor and whether you can monetize the idea.
Once the entity is formed, the best way to prevent it from becoming dormant is to maintain all corporate formalities, timely file and pay all taxes, and continually plan and evaluate financial information on a routine and systematic basis. Additionally, be sure to have a backup plan for if an owner or key employee becomes sick or incapacitated. Lastly, have a relationship with a team of professionals that you trust, who can guide you through the tough times that all small businesses encounter during their respective life cycles.
If you are looking to add an Attorney, CPA, or both, who focuses exclusively on small businesses to your brain trust, I would be happy to hear from you!