California Business Divorce Blog: Winding Up an LLC in California: A Guide for LLC Members Following a Business Divorce

When the members of a California limited liability company (LLC) decide to part ways, it is crucial to properly dissolve and wind up the business by addressing important legal and business obligations.  

As discussed below, failing to take the necessary steps can result in lingering risks and liabilities for LLC members. 

Procedural Steps to Dissolve an LLC in California

When members of a California LLC “divorce,” their business partnership may end, but the underlying business, itself, remains in existence. It’s therefore important for the members to take the appropriate steps to dissolve the LLC in order to fulfill their legal obligations and reduce risks of personal liability.

The first step in dissolving a California LLC is reviewing the company’s organizational documents, such as the articles of organization and operating agreement. These documents typically include a “roadmap” for the dissolution process, such as the need for a vote by LLC members, and the voting percentage required to proceed with a dissolution.

If the operating agreement does not specify a dissolution process, the California Revised Uniform Limited Liability Company Act (RULLCA) provides default rules which allow for an LLC to be dissolved upon a majority vote of its members 

Once the decision to dissolve has been made and documented, the LLC must file a Certificate of Dissolution (Form LLC-3) and Certificate of Cancellation (Form LLC-4/7) with the California Secretary of State. However, if all the members vote to dissolve, only a Certificate of Cancellation is required. As discussed below, the Certificate of Cancellation should be filed after certain other actions, such as tax filing requirements, are addressed.

Addressing Tax Requirements

The LLC must file final federal and state tax returns and ensure that all taxes owed are paid. In California, the LLC should also obtain a tax clearance certificate from the California Franchise Tax Board (FTB). This certificate verifies that the LLC has paid all outstanding taxes and penalties. When filing a Certificate of Cancellation, members must state that, “All final tax returns required under the California Revenue and Taxation Code have been or will be filed with the California Franchise Tax Board. 

The Internal Revenue Service has its own set of requirements a business must take to close business from a federal tax perspective, regardless of your business type. These requirements, which are set forth here, include:

1. Filing a final return and related forms
2. Taking care of employees
3. Paying owed taxes
4. Reporting payments to contract workers
5. Canceling your EIN and closing Your IRS business account
6. Keeping records

Notifying Creditors, Resolving Claims, Disposing of Assets, and Distributing Proceeds

California law requires that an LLC winding up its affairs must notify known creditors via mail of the dissolution. Additionally, the LLC may choose to publish a notice of dissolution in a newspaper of general circulation in the county where the LLC's principal office is located for the purpose of informing unknown creditors of the LLC's dissolution. The LLC should settle outstanding debts and resolve creditor claims accordingly.

The winding up process may also involve defending against claims pending or brought against the business, as well as initiating actions, as appropriate, to collect debts owed to the business. Non-cash assets should also be monetized through a liquidation or other sale.

Once assets are marshaled and claims resolved, assets are to be distributed to satisfy debts, including debts and liabilities to members who are creditors of the LLC. Any remaining assets are to be distributed among the LLC members according to their respective rights as follows:

1. To members in satisfaction of liabilities for distributions pursuant to Section 17201, 17202, or 17255 of the RULLCA.
2. To members of the limited liability company for the return of their contributions.
3. To members in the proportions in which those members share in distributions.

There is the potential for lingering liability for LLC members who receive distributions from the LLC during the winding up process. In particular, causes of action against a dissolved LLC, whether arising before or after dissolution, may be enforced against members to the extent of the assets distributed to them upon dissolution of the LLC.

Practical Steps for Winding Up an LLC

In addition to legal requirements, there are several practical steps that LLC members should take to tie up loose ends and ensure a smooth transition.

1. Address Contractual Obligations: Review existing contracts and agreements, and terminate or transfer them as necessary. Consult with a business lawyer to ensure that all contractual obligations are properly addressed.
2. Handle Employee Matters: If the LLC has employees, provide notice to them and resolve any outstanding payroll and benefits issues. Be sure to comply with the California Worker Adjustment and Retraining Notification (WARN) Act if applicable.
3. Close Business Accounts and Lines of Credit: Close bank accounts, settle any outstanding debts or loans, and cancel credit cards associated with the LLC.

Filing a Certificate of Cancellation

After dissolving and winding up the affairs of an LLC, a certificate of cancellation must be filed with the California Secretary of State using form LLC-4/7. To the extent that an LLC has been in existence for less than 12 months, and certain other conditions are met, short form LLC-4/8 can be used for cancellation.

Risks of Failing to Properly Dissolve and Wind Up a California LLC

Failing to properly dissolve and wind up an LLC can have significant legal, financial, and reputational consequences. Here are some potential risks that LLC members may face if they do not fulfill their obligations:

1. Legal Liabilities: If an LLC is not properly dissolved, its members could potentially be held personally liable for the company's unresolved debts and legal obligations. This is especially true if the LLC fails to notify creditors of the dissolution or does not properly handle creditor claims. Additionally, members might face lawsuits from creditors, suppliers, customers, or employees.
2. Tax Penalties and Consequences: If the LLC fails to file final tax returns or obtain tax clearance from the California Franchise Tax Board, the members could face fines, penalties, and interest charges. The LLC could also remain liable for ongoing taxes and fees, such as California's annual minimum franchise tax, until the dissolution process is properly completed.
3. Reputational Damage: If an LLC is not properly wound down, it can damage the reputation of the business and its members. This could make it more difficult for members to secure financing, establish new business relationships, or pursue other business opportunities in the future.
4. Ongoing Obligations: Until an LLC is officially dissolved, it may still have ongoing obligations, such as annual report filings, franchise tax payments, or business license renewals. Failing to meet these obligations could result in additional penalties. 

The Importance of Seeking Legal Counsel

Winding up an LLC in California can be a complex process. Seeking the guidance of an experienced California business lawyer can ensure compliance with laws and regulations, identify potential legal risks, and help draft and review necessary dissolution paperwork. Legal counsel can also assist with contract termination or modification and mediate disputes between members, facilitating negotiation and resolution, or representing clients in litigation if necessary.

If you have questions or require assistance, please contact Jason Anderson or Jeremy Suiter.