The High Cost of Failing to Qualify as a Foreign Corporation

Failing to comply with the requirement to qualify as a foreign entity in Connecticut recently proved costly for hundreds of companies. As part of a crackdown on foreign corporations that failed to properly register and qualify in Connecticut, the offices of the Secretary of the State and the Attorney General fined more than 350 out-of-state companies nearly $1.8 million. Companies were fined anywhere from a few hundred dollars to more than $45,000 over the course of the 2015 fiscal year.

Connecticut isn’t alone in its efforts to police foreign corporations that are doing business within its borders without first obtaining the authority to do so. Many other states also have strict rules and regulations requiring out-of-state companies to qualify in order to do business, with varying penalties for failing to comply. Under the Illinois Business Corporation Act, any corporation that transacts business in Illinois before it obtains an authority to do so faces fines and other penalties. In addition to fees and franchise taxes, there is a penalty of $200, plus $5 per month, or 10 percent of fees and taxes, whichever is greater.

The consequences for failure to comply can extend beyond monetary penalties. Companies may be barred from using a state’s court system if they haven’t qualified as a foreign corporation when required to do so. That’s what happened in one recent case, Drake Manufacturing Company, Inc. v. Polyflow, Inc. Delaware-based Drake, a supplier of industrial products, attempted to sue Polyflow in Pennsylvania Superior Court for failing to pay for machinery and pipe fittings. Polyflow claimed that Drake did not have the standing to bring a lawsuit in Pennsylvania, since it was conducting business there without the required certificate of authority. While Drake eventually produced an overdue certificate, the Pennsylvania Superior Court tossed the lawsuit in January 2015.

Along with fines and being barred from court systems, failing to properly qualify can cause other problems. According to the office of the Texas Secretary of State, some banks will not do business in the Lone Star State with a foreign entity that has not qualified.

As these enforcement programs and regulations demonstrate, the consequences for companies that fail to qualify can be quite damaging. It is essential that all organizations keep an eye on the compliance regulations in every state where they do business. Since every state has its own rules and regulations for foreign corporations, it can sometimes be difficult to remain compliant. Yet failing to do so can be far more expensive.

Qualifying as a “Foreign Corporation”

To explain the crackdown in Connecticut, Secretary of the State Denise Merrill released the following statement: “Here in Connecticut, we strive for fair competition in the marketplace so that all businesses in the state have a chance to make a profit in this economic climate. Whether intentionally or not, out-of-state companies that fail to register and obtain a certificate of authority to do business here undercut Connecticut companies and make it difficult to provide accountability for Connecticut consumers.”

This statement helps to underscore why nearly every state requires companies doing business in the state to qualify.

The foreign qualification process generally requires organizations to file documents with the appropriate state agency, pay a fee and appoint a registered agent in that state. A registered agent receives essential state mailings (annual reports, tax forms, etc.) and legal documents (such as summonses and complaints, subpoenas or court orders) and relays them to individuals within a business.

A company that is foreign-qualified receives a certificate of authority (or similar document) from the state. The certificate of authority is evidence that the company has the right to transact business in that state. To maintain this status, the company will have to comply with certain requirements, such as having to file an annual report with the filing office in all the states in which it is foreign qualified.

Another option is for companies to form an entirely new entity in the given state. However, there are consequences to doing so. For one, a domestic entity is subject to far more compliance requirements than foreign entities. A separate domestic corporation, for example, has to appoint a Board of Directors and officers, draft bylaws, maintain books and records, hold annual shareholder meetings, issue shares and so on. It may also have to obtain its own licenses. There are tax implications as well. A domestic entity may be subject to taxation on its entire income in its domestic state, while a foreign entity may only be subject to taxation on that part of its income apportioned to the foreign state.

How Do You Know If You Must Foreign Qualify?

To complicate matters, there are no uniform standards across states for when businesses have to qualify as a foreign corporation. As a general rule, companies that have a physical presence or employees in the state or that accept contracts in intrastate commerce will probably need to qualify. As companies expand into different states, the situation becomes even more complex. A trusted advisor such as an attorney can provide guidance to help you make the best decision given your company’s circumstances.

A registered agent can help with the process of qualifying in each state — which can be tedious and time-consuming and can result in errors if not undertaken properly. (According to the website of the office of the California Secretary of State, “Many corporation, limited liability company and limited partnership documents are returned for correction without being filed because of name issues, errors, omissions or misstatements contained in the proposed filings” submitted to the office.)

When companies expand beyond the borders of their state of formation, determining whether foreign qualification is necessary (and qualifying if it is) needs to be on compliance officers’ list of to-dos. Doing so will help to ensure that companies avoid fines and other penalties and can use the state’s court system.