Starting a business this summer? After deciding to form a corporation or LLC, you also need to consider which state you plan to incorporate in: Do you want to incorporate where you live (also known as home state incorporation)? Or incorporate in another state like Delaware or Nevada?
Each state varies in terms of filing fees, taxation, and corporate laws. You’re not legally required to incorporate in the state where you operate your business, so many people think they’re better off incorporating in a “tax-free” state like Nevada or a “business-friendly” state like Delaware. But is that really the case?
You also need to weigh your administrative costs, as it’s going to be more complicated to incorporate in a state other than where you live and run your business. In most cases, a small business will be better off incorporating or forming an LLC in the state where it is located and operates its business (aka, its “home state”).
Below explains why that’s the case.
How to Choose Where to Incorporate
Nevada and “Tax-Free” States
While some states have tax rates as high as 10%, Nevada has no franchise, corporate income, or personal income taxes. The chance to avoid paying state taxes sounds very appealing, and certainly it would be advantageous for you to start or move a business to Nevada for this reason.
However, if you’re running a business from another state, there’s really no tax benefit for incorporating in Nevada. That’s because each state requires businesses that operate within its borders to pay tax on sales or revenue that originates within the state.
For example, let’s say you operate a business from your home in California. You decide to incorporate your business in Nevada because you’ve heard there’s no state income tax there. However, because you’re actually operating your business in California, you also have to register your business in California (this is also called “foreign qualify”). And, you have to pay state taxes to California.
As the saying goes, nothing is certain but death and taxes.
States With Low Filing Fees
In addition to tax rates, states also vary in terms of the filing fees associated with incorporating and maintaining a corporation. Many small business owners think that they can save money by incorporating in a state like Nevada with low filing fees.
However, if their business is located or conducts business in another state, they’ll have to foreign qualify in their home state and will end up paying their home state’s filing fees anyways. And many small businesses end up paying penalties for conducting business before foreign qualifying in the state.
In short, a company will end up paying corporation maintenance fees wherever it conducts business, so there’s not much advantage in choosing a state of incorporation based on the filing fees.
Delaware and “Business-Friendly” Statutes
Delaware is known for having one of the most flexible, pro-business laws in the country. Historically, it has given management flexibility in terms of how to operate its business. Delaware also has a separate court for business matters that uses judges instead of juries. Cases are often resolved more quickly because of this.
Both of these factors are typically a big advantage for publicly traded companies and large corporations with nationwide shareholders. But, the advantages aren’t usually important for small businesses. For starters, complex business litigation is not common for a small business. And most small businesses tend not to have complex stock situations.
The Bottom Line: Do You Have Fewer Than Five Shareholders?
As a general rule of thumb, if your business has fewer than five shareholders, you probably won’t benefit from Delaware’s more business-friendly statutes. When your business is small, the benefits of incorporating in Delaware or Nevada will be outweighed by all the extra costs and administration created by incorporating in one state and foreign qualifying in another. But for larger businesses with more complex tax and stock situations, it is most likely worthwhile to pick a business-friendly state for incorporation.
By incorporating in a state other than your home state, you are essentially doubling the paperwork and administration for running your business. In the example above, you’d need to send in your Annual Statement (and fees) to both California and Delaware. And since you don’t have an actual physical location in Delaware, you will need to appoint a Registered Agent in the state in order to have a proper address on record.
It’s easy to get caught up in the all the hype associated with Delaware, Nevada, and Wyoming. But these benefits are really limited to larger businesses. As a small business owner, you don’t have a huge accounting team to handle all your paperwork and filings, so there’s no reason to add more to your workload by incorporating in another state.
If your company has fewer than five shareholders/members, the simplest route of incorporating in your home state turns out to be best.
Map Photo via Shutterstock
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Taxes, taxes, taxes… While I hate to admit it, it really plays an important factor on how small business owners construct their business. They need to consider the taxes of a particular location before they can proceed. But more than knowledge on location taxes, the return on investment based on the number of people in the area and the type of product or service should also be considered.
Great article!
If a small business does not comply with the filings and tax rules of the state, they chance putting their company in danger of being administratively dissolved and losing the desired legal protection.
As a small business and corporate board adviser I have found that it is always prudent to establish relationships early with your professional advisers (even if you can only initially afford to pay for a “check-up” in the early stages of development).
Before major business complications or an actual “situation” a small business can save thousands of dollars by engaging (or at least establishing a relationship) with a qualified business attorney, bankers, business insurance broker, CPA, etc… The business can usually save money because more time can be spent providing advice versus getting generally acquainted with your business.