Choosing the Best State to Incorporate

Summary

There is no legal requirement to form your new corporation or LLC in your home state (the state where your principal business is located). For a small business corporation that primarily or exclusively does business in its home state, there is rarely an advantage to incorporating in another state because you will still be required to register your out-of-state (foreign) corporation in your home state and pay the same fees and taxes.

Note: For purposes of this topic, corporation will include all entity types unless stated otherwise.

Discussion

One of the first decisions a business owner must make after deciding to incorporate is where to incorporate. The common choice is your home state where your business is located and this is usually the best choice, though not legally required. However, many people believe that there are advantages to incorporating in one of the “tax-free” states or a so-called “corporation-friendly” state like Delaware. Since you are not required to incorporate your business in the state in which you operate your business, you may choose any of the 50 states. But should you?

Your decision should be based on consideration of 3 main factors:

• Tax considerations
• Cost considerations, and
• Jurisdictional considerations.

In all but exceptional cases, a small business will conclude that it is most advantageous and convenient to incorporate your business in the state in which the principal business is located and operates – the business’ “home” state. A short discussion of these factors will explain how this conclusion is reached.

Tax Considerations

Although the primary characteristics of corporations are similar from state to state, the applicable tax rate is not. Some states have tax rates as high as 10%. Nevada, on the other hand, has no franchise tax and no state income tax. Income tax considerations will generally not apply, however, to an entity that is not taxed at the business level, such as an LLC or S Corporation.

It certainly would be advantageous to start or move your business to Nevada to enjoy these tax advantages. However, if you’re operating your business in a different state, incorporating in Nevada won’t excuse you from paying business taxes in your home state because every state requires businesses operating within its borders to pay tax on sales or revenue that originates within the state. More on this later.

Cost Considerations

Although retaining an attorney is not required to incorporate your business, seeking legal counsel is advisable due to the complexities of the process. Thus, if you are considering incorporating out of state, consulting with legal counsel licensed and practicing in the incorporating state may represent an additional cost if you already obtain legal advice in your home state.

Every state requires a corporation to have a resident agent for service of process located at a physical address within that state. Many private service companies offer resident agent services in all states. The typical fees are between $125 and $200 per year. If you don’t have a physical address in the incorporating state, you’ll be required to pay an authorized company an annual fee for this service.

Finally, every state requires a foreign (out-of-state) corporation to register, or qualify, before conducting business within that state. This process involves filing paperwork with the foreign state, paying filing fees, and possibly paying penalties for conducting business prior to registering as a foreign corporation. It also imposes the same or similar annual reporting requirements and franchise and/or income tax obligations on the foreign corporation as are imposed on domestic corporations. In short, a corporation will usually wind up paying corporation maintenance fees and taxes in its home state as well as the foreign state where it registers.

Jurisdictional Considerations

If a business headquartered in one state is incorporated elsewhere, it will be subject to jurisdiction and service of process in the foreign state of incorporation. This may prove to be inconvenient for a variety of reasons.

First, subjecting your corporation to service of process in the state of incorporation means that any legal notices and/or communications from the state will be sent to your registered agent in that state. Materials may therefore be delayed as your registered agent forwards them to you. Time-sensitive materials may be misplaced or may not reach you in time.

Second, subjecting your corporation to another state’s jurisdiction usually means that your corporation is governed by the laws of that state, which may differ from those of your home state. An important consequence of this is that the court system in your corporation’s state will probably require you to appear in court in that state if any legal disputes arise (for example, if a creditor is attempting to collect a debt owed by your corporation).

Some “Corporation-Friendly” States: Delaware and Nevada

Delaware

Delaware has long been touted as one of the best states in which to incorporate. In the past, Delaware had the most liberal incorporation statute in the country, which gave management great flexibility in operating the corporation’s business. This flexibility was a great advantage to huge corporations that do business and have shareholders nationwide (or worldwide). However, this advantage is usually not important for smaller corporations. Also, most states have modernized their corporation statutes to make their laws more comparable to Delaware.

One long-standing advantage in Delaware is the existence of a separate court for the resolution of business disputes. Cases are often resolved more quickly and have the benefit of judges that are experienced in business cases rather than potentially being decided by a former prosecutor judging a complex business case.

For a small business that where complex business litigation is a remote possibility, however, the advantage Delaware may offer to a Fortune 500 publicly traded company is not likely to apply.

Nevada

According to the Nevada Secretary of State, the following are some of the “Top Reasons to Incorporate in Nevada”:

• No Corporate Income Tax
• No Taxes on Corporate Shares
• No Franchise Tax
• No Personal Income Tax
• Nominal Annual Fees

There is no question that these are top reasons for a Nevada-based business to incorporate in Nevada, but do these advantages apply to a business located in another state and doing little or no business in Nevada? The simple and unqualified answer is a definitive “no” and there is no explicit claim by the Nevada Secretary of State or any reputable Nevada incorporation service that any of these tax advantages apply to a business located outside Nevada.

The reason is simple: a business located in another state, for example, California, cannot simply form a Nevada corporation to run a California-based business and thereby avoid paying the fees and taxes normally imposed on businesses operating in California.

Think about it for a moment. If you operate a retail clothing store in New York, own a restaurant in California, or have a computer repair service in Illinois, and you could avoid paying business income taxes in your home state merely by incorporating in Nevada (or Wyoming), why would you ever incorporate your business in your home state? You wouldn’t.

Protection for Personal Assets

Some Nevada-based incorporation services have also promoted Nevada’s advantages to include superior liability protection for the personal assets of the owners and better privacy to operate anonymously as an officer, director, or shareholder in a Nevada corporation. The truth is:

• Nevada, like all states, requires a corporation to file an annual report (in Nevada it’s called an Annual List of Officers and Directors) that lists the names and addresses of the corporation’s officers and directors. This is a public record that anyone can access directly on the Nevada Secretary of State website.
• While shareholders’ names and addresses are not required by Nevada’s Annual List, neither are shareholder names required in the annual reports of virtually all other states.
• The personal liability protection offered by a Nevada corporation is no greater than it is in other states. In fact, if you research the Nevada Revised Statutes, you’ll find a law that describes the circumstances where a court may disregard the corporation and hold the shareholders personally liable and subject their personal assets to satisfying a judgment. You’ll also learn that the origin of this Nevada statute was a landmark case in California where the appellate court listed numerous factors for courts to consider in determining whether the corporate entity should be disregarded and shareholders held personally liable.

In short, there is rarely an advantage for a business located outside of Nevada to incorporate in Nevada.