It Now Pays Dividends to Be a California Corporation!

For those of you who believe California is not the most business friendly state in the union, here is a bit of good news which you may not be aware of. Assembly Bill 571 (“AB 571”), sponsored by the Corporations Committee of the State Bar of California, became effective as of January 1, 2012. AB 571 streamlines and simplifies the legal requirements governing distributions to shareholders by a California corporation in a manner that is more consistent with similar laws of other well recognized states.

Under the prior law, California corporations were permitted to make distributions only if they satisfied a general solvency test and one of two additional tests: a retained earnings test or a two-pronged balance sheet and liquidity test. A “distribution” includes any transfer of cash or property by a corporation to its shareholders (other than stock dividends) and any redemption by a corporation of its shares for cash or property (a business point often requested by angel investors and venture capitalists when investing in early stage companies). AB 571 did not modify the general solvency test, which prohibits a California corporation from making a distribution if the corporation is (or would become as a result of the distribution) unable to meet its liabilities as they mature. But, AB 571 eliminates the two-pronged balance sheet and liquidity test and replaces it with a new, simplified balance sheet test.

This new balance sheet test allows a corporation to make distributions if immediately after the distribution, the value of the corporation’s assets equals or exceeds the sum of its total liabilities plus the preferential rights amount (which is defined as the amount that would be needed to satisfy preferential rights, including accrued and unpaid dividends, of other shareholders that are superior to the rights of the shareholders receiving the distribution).

AB 571 also provides significant discretion to boards of directors for calculating the amount of the subject corporation’s assets and liabilities under the new balance sheet test. Specifically, the board of directors may base a determination that the value of the corporation’s assets exceeds the amount of its liabilities on financial statements prepared on the basis of accounting practices and principles that are deemed reasonable under the circumstances, a fair valuation, or any other method that is reasonable under the circumstances. Under the old statute, however, a corporation’s assets were generally required to be valued at their historic carrying value and certain assets and liabilities were excluded altogether. Since the historical carrying value of assets on a corporation’s book is not necessarily reflective of the current fair market value of those assets, and in many cases the actual fair market value exceeds the carrying value of those assets, under the old statute, a corporation with assets having a fair market value far in excess of its liabilities could still fail to satisfy the balance sheet test.

The effects of the old statute had the most severe impact on shareholders of S corporations. Because of its “flow-through” nature, shareholders of an S corporation often have a need for distributions in order to satisfy personal income tax obligations. The old statute in many circumstances prohibited distributions for the reasons stated above even though the same restrictions would not have applied to a California limited liability company with identical financial statements. The old statute focused on whether a corporation’s actual balance sheet entries satisfied the balance sheet and liquidity test, regardless of whether the corporation’s balance sheet actually reflected the fair value of the relevant assets and liabilities.

In short, the passage of AB 571 helps modernize the guidelines and loosen the strict legal thresholds governing distributions made by California and quasi-California corporations to their shareholders, providing a more pragmatic approach that is also more consistent to the restrictions on distributions applicable to California limited liability companies.