Small Business Taxes & Management^TM--Copyright 2010, A/N Group, Inc.

Introduction

Over the years we've had inquiries on the best state in which to incorporate or start an LLC. Rumor has always been that Nevada and Delaware are the best states for various reasons. For many businesses, their home state makes the most sense, for a number of reasons. A quick look at the facts and costs will make it clearer.

Delaware

For large corporations this is the state of choice. The reason is simple. The courts and government are friendly to management. That can be critically important in a shareholder fight, a takeover by another corporation, etc. Chances are Madison Inc., a corporation with $500,000 in sales and Fred and Sue Flood as the sole shareholders won't have to worry much about this. The same is true of the fact that Delaware corporate law is well settled.

One advantage for a small corporation is that one person can hold all the offices of the corporation. That can be an issue for small entities, but a number of other states allow one person to hold all the offices and, if not, it's not an insurmountable obstacle.

Fees are low and you won't have to file an income tax return if you don't do business in the state. No shareholders or officers have to reside in the state.

Nevada

This state is the other most popular state for incorporation. The prime reason is that there is no corporate income tax, no franchise or personal income tax, and the fees are low. But for many incorporators, the most important reasons are that stockholders are not in the public record, Nevada does not share information with the IRS, and privacy is respected even if the corporation doesn't follow the usual corporate formalities.

In addition, directors don't have to be shareholders, corporate meetings don't have to be held in the state, and officers and directors are generally shielded from personal liability for corporate acts that are lawful.

Home State

While incorporating in your home state (where your operations are located) may or may not have any advantages, it's unlikely you'll be able to avoid registering and paying taxes there. In fact, any state in which you're doing business will require you to register as a foreign corporation (an entity not incorporated in that state; a domestic corporation is one incorporated in the state). That may offset any savings in filing fees. For example, a domestic New York corporation could escape with the minimum $25 fee when filing income taxes. A foreign corporation in New York must pay an annual $300 registration fee (in addition to any required taxes). Massachusetts has a $300 entrance fee for foreign corporations, but no annual fee other than one for an annual report which is the same for both foreign and domestic corporations.

Don't want to bother to register? The penalties for doing business in a state without authority vary widely. In a number of states the Attorney General can restrain the corporation from doing business. In Massachusetts you can be liable for a $500 penalty for each year you're in noncompliance. In Nevada you cannot sue, maintain, or defend any action in court. If you're required to file a tax return and don't, the statute of limitations does not begin to run. You could find yourself liable for any number of years' of taxes back to the first day you started doing business in the state. With penalties and interest, that can turn out to be a significant amount.

Are you doing business in the state where the business is physically located? It's pretty tough to avoid it if you have people or property in the state.

Example--Madison Inc. is a Nevada corporation wholly owned by Fred Flood who lives in New York. Madison has New York sales but has no inventory. All orders are taken over the internet through an operation in Wyoming (which has no income tax). Fred manages the company from his home in New York using computers and furniture purchased by the corporation. That means Madison has people (Fred) in New York and assets in New York and the state would probably hold that the corporation is doing business in New York and liable for income taxes.

Keep in mind that most states require some presence in the state to receive service of process, etc. That means you'll have to have a registered agent in the state. While there are a number of businesses that perform this service, it can easily cost $250 a year. Not much for a large corporation, but it's a factor to consider for a small entity.

You could encounter another problem. That great corporate name you registered in Nevada that you were going to use to gain brand recognition can be still registered in any state where it isn't already taken. Thus, just because you incorporate We'll Give You Free Money, Inc. in Nevada doesn't mean someone else can't register that name in Ohio.

When Would a Nevada or Delaware Corporation Make Sense?

There are a number of situations we can think of. First, if you want to set up a corporation to get the business started, but don't know in what state it will be operating. For example, a software or biotech company where the principals are located in different parts of the country. Second, you anticipate your business to quickly advance from a single to a multistate operation. The advantages of a Delaware corporation may be particularly attractive. Third, the corporation won't be operating (at least for a while) but will hold an intangible such as a patent, manuscript, etc. In that case there may be no assets or employees in your home state. In fact, Delaware has been used as home for corporations holding intangibles such as trademarks, etc. Finally, incorporation in Delaware or Nevada (or another state) may have one or more special advantages. For example, incorporation of a venture in Nevada would make sense where you want the identity of the shareholders to be kept secret.

What about LLCs?

Many of the same rules that apply to corporations apply to LLCs. Setting one up in Delaware won't do you much good if you're going to operate a retail business in New York. You'll have to register and pay taxes there regardless of where you set up the LLC.

Keep in mind that LLCs are toddlers compared to corporations. There are still differences among the states and the law regarding them is much less settled.

Parting Points

While you can merge a corporation into another one set up in a different state, or dissolve the first corporation and set up another, generally the longer the corporation has been in existence, the more costly it will be to do so. There are ways to do so with no tax consequences, but a mistake here could prove costly. Your state of incorporation shouldn't be taken lightly. Get advice from a competent professional.

--Last Update 06/17/10