Key Takeaways

  • De facto liquidation occurs when a business winds down and distributes assets without following all formal dissolution procedures.
  • Members of an LLC may still have fiduciary duties after dissolution, especially if they continue similar operations or profit from company assets.
  • California law provides certain liability protections for LLC members, but exceptions exist for personal guarantees, fraud, or improper asset distribution.
  • Tax consequences of de facto liquidation can affect both businesses and shareholders, depending on solvency, asset appreciation, and timing.
  • Courts may impose successor liability in de facto mergers, making asset purchasers responsible for the predecessor’s obligations.

De facto dissolution refers to the dissolution of a corporation and the liquidation of all its assets.

What Is De Facto Dissolution?

A company that goes into dissolution suspends all of its business transactions and liquidates the assets of the company. Dissolution of a company often brings up a lot of questions and financial concerns. The company and its members may wonder if they are liable for legal actions against the company after it has already been liquidated. There are a lot of factors that go into the legal consideration against a de facto dissolution company.

De Facto Liquidation vs. De Facto Merger

While de facto liquidation focuses on the winding up of a company’s affairs, a related concept is the de facto merger doctrine. This arises when an asset purchase resembles a merger so closely that courts treat it as one. In such cases, the acquiring company may inherit the seller’s liabilities, even if the transaction was structured as an asset purchase. Courts typically look for factors such as:

  • Continuity of ownership between the seller and buyer.
  • Continuity of management, personnel, and business operations.
  • Assumption of ordinary business obligations by the buyer.
  • Whether the seller ceases operations after the transfer.

This doctrine prevents businesses from avoiding liabilities by disguising mergers as simple asset sales. It underscores that both de facto liquidation and merger principles can unexpectedly create obligations long after a company is thought to be dissolved.

De Facto Dissolution of an LLC Does Not Terminate Members' Fiduciary Duty

A recent legal decision claims that the LLC fiduciary responsibility is not forgiven simply because the company has been liquidated. Additionally, if members of the liquidated LLC continue to do business through the LLC name or if they create a separate but similar business, they are liable for any financial responsibilities.

Continuing Duties and Member Accountability

Case law demonstrates that members’ fiduciary duties can survive a de facto dissolution. In one New York appellate decision, members who attempted to appropriate profits from ongoing business operations after the LLC’s effective break-up were still held accountable. The court emphasized that:

  • Fiduciary duties persist until formal dissolution and winding up are complete.
  • Members cannot exploit company opportunities for personal gain without disclosure.
  • Courts may order accountings or restitution if members profit improperly after de facto dissolution.

This means that even when a company is no longer active, members must act in good faith, avoid conflicts of interest, and respect the equitable rights of co-owners.

De Facto Dissolution of a California LLC

California takes a unique stance on the legal liability of LLCs after liquidation. According to California law, members of an LLC are not personally liable for any debts or financial obligations. However, there are exceptions to this rule. Exceptions include:

  • The liability of a member under the equitable alter ego doctrine.
  • Co-signing for debt incurred under the LLC business name.
  • The guarantee of performance with a contract agreement.
  • Liability for the personal actions of an LLC member, whether or not they were acting on the behalf of the business LLC.
  • A lack of disclosure when entering into a contract agreement.
  • The removal of LLCs assets in a malicious intent.
  • If the LLC has undistributed assets (i.e., in the form of an insurance policy).
  • If assets were distributed to the members of LLC after liquidation, but before formal dissolution. The responsible liabilities, however, are limited to the amount received after the liquidation.

In order to evaluate whether or not an LLC is liable for financial responsibilities after dissolution requires that an exact date of dissolution is specified. In most cases, the only public record that has this information is the statement of dissolution that is filed with the state. This document, however, does not always determine the exact date of the dissolution.

According to the California Revised Limited Liability Company Act, a company is considered dissolved when one of the following occurs:

  • An event takes place on a specific date, and that is specified in the Articles of Organization.
  • If 90 days have passed and the LLC has no remaining members.
  • There is a judicial statement of de facto dissolution.
  • The members vote to dissolve the company and its assets.

In many cases, assets are already distributed before any of these events occur. By the time a judgment is made, there are no remaining assets left to pay them. This is where things can get complicated. The judge must determine if the previous actions occurred before the assets were distributed and if the financial obligations are payable.

Tax Consequences of De Facto Liquidations

Many also wonder if there are tax liabilities on a liquidated LLC company. If an LLC is liquidated for income tax purposes, there will likely be tax consequences for the company and its former members. The exact de facto liquidation date is important when determining tax liabilities, too. The date of the liquidation will determine the liable tax year. Some businesses take many years to fully liquidate, and this can make it difficult to establish a liable tax year.

Generally speaking, the most important factor to consider is whether or not the company was solvent at the time of full liquidation. Additional factors that are taken into account include:

  • Gains to the fair market value of any property.
  • Materially appreciated assets (if any are present).
  • The net operating losses of the company.
  • Whether or not the liquidating company is involved in foreign investments.

The factors that determine liability vary depending on the individual features of the business. It is important that tax professionals are always aware of the implications of de facto liquidation businesses, both in a domestic and foreign setting.

IRS Perspective on De Facto Liquidation

For tax purposes, a corporation or LLC may be treated as having undergone a de facto liquidation even if no formal dissolution documents are filed. The IRS generally looks for three elements:

  1. A manifest intention to liquidate, communicated to shareholders or members.
  2. A continuing purpose to wind up the company’s affairs.
  3. A completion of activities directed toward termination within a reasonable time.

If these conditions are met, the IRS may treat distributions as liquidation proceeds rather than dividends, triggering capital gains or losses for shareholders. Importantly, timing matters—delays in completing liquidation can affect which tax year liabilities apply.

Practical Tax Planning Considerations

Businesses and their advisors should carefully document liquidation steps to avoid disputes with the IRS. Key strategies include:

  • Maintaining written records of board or member resolutions to dissolve.
  • Ensuring distributions are properly reported and categorized.
  • Considering the impact on net operating losses, foreign subsidiaries, or appreciated assets.
  • Being mindful of the “step transaction” doctrine, under which piecemeal distributions may be collapsed into a single liquidation event.

Failure to anticipate these issues can create unexpected tax bills for both the company and its owners.

Frequently Asked Questions

  1. What is de facto liquidation?
    It occurs when a business distributes assets and ceases operations without formally dissolving under state law, creating legal and tax consequences.
  2. How is de facto liquidation different from de facto dissolution?
    De facto dissolution refers broadly to winding up operations, while de facto liquidation often describes the tax treatment of asset distributions in such cases.
  3. Can LLC members still be liable after de facto dissolution?
    Yes. Courts may enforce fiduciary duties or claw back assets if members misuse company property or benefit unfairly after dissolution.
  4. What are the tax implications of a de facto liquidation?
    The IRS may treat distributions as liquidating, resulting in capital gains or losses for shareholders, depending on asset values and timing.
  5. What is the de facto merger doctrine?
    It applies when an asset purchase effectively functions as a merger. Courts may impose successor liability on the buyer for the seller’s debts.

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