When setting up new businesses, I frequently get asked which state is best to incorporate in. Often, clients come with plans in mind to use places like Delaware, Nevada, or Wyoming, because they have read something online or heard of some sort of tax advantage from a friend. More often than not, these plans wind up being ill-conceived, with the state the business is actually located in winning out. However, with that in mind, circumstances certainly exist where using a different state provides a particular benefit which makes doing so make sense.
In this post I’m going to discuss: (1) when it makes sense for a business to incorporate in their home state; (2) when it makes sense to incorporate elsewhere; and (3) the process of incorporating elsewhere. As this is Austin Business Advisor, this post is written from the perspective of a business with operations primarily in Texas (its “home” state).
When Your Business Should Stay Home
In most cases, the answer to the question of where to incorporate is simple. Its the state the business is located in, or its “home state”. There are two primary reasons for doing so: (1) lack of a real tax reason for leaving the state, and (2) additional filing obligations in leaving the state.
One of the main reasons that clients point to when suggesting “foreign incorporation” (i.e., incorporating in a state other than the home state of the business) is a perceived tax savings in doing so. States like Nevada and Wyoming do not have an income tax, and as a result, some entrepreneurs misunderstand this to mean that incorporating in one of these states will eliminate state income taxes for the business. Note this reason is cited much less often by my Texas clients, as the Texas revised franchise tax is much lower than most state income taxes and rarely even applicable to many, small and mid-sized businesses.
While proper state and local tax planning can, in some circumstances, reduce or eliminate state tax income, state income tax principles dictate that state taxes will be assessed by states according to complex apportionment formulas and rules. However, this post is not intended to explain state income tax apportionment rules, and for purposes of the topic of this article, it is only important here to understand that states will typically assess income taxes on the income of the business that has a legal “nexus” or sufficient connection to that state (based upon complicated tax rules), regardless of where the business is incorporated. As these formulas are typically based on the location of (1) sales, (2) property, and (3) payroll, for many businesses, application of state apportionment rules often results in the same amount of state taxes being assessed regardless of where the business is incorporated in.
Another reason that foreign incorporation often makes little sense is that doing so often imposes additional filing requirements, which can both (1) add extra costs and filing fees, and (2) actually negate the intended benefits of the foreign incorporation. Regardless of the state a business is incorporated in, a business will have filing obligations in states it is “transacting business” (the legal term applied in Texas). Often the threshold for what constitutes “transacting business” (or an analogous concept) is quite low, generally imposing a filing requirement on businesses which have property, an office, or employees within the state, or are in the state to “pursue one of their purposes” (language from Texas guidance). This filing obligation is often referred to as “foreign entity registration,” and for policy reasons often costs more than simply organizing a new entity in the state.
For example, if a business operating exclusively in Texas decides to incorporate in Delaware, its filing fees will be almost three times the cost of just incorporating in Texas (approximately $839 vs. $300). In Texas, the foreign entity registration filing fee is $750, while the fee to organize a new entity is only $300. With the additional cost of incorporating in Delaware ($89), it is apparent that unless there are other, important reasons to incorporate in elsewhere, some of which are discussed below, a Texas business should save themselves some money and extra effort by just staying at home.
When Your Business Should Leave the State
As discussed above, the home state of a business is often the best and easiest state to incorporate in. However, there are plenty of reasons for a company to incorporate in a state other than their home state, with some of the more common including: (1) privacy concerns, (2) lower annual filing fees, (3) certain types of businesses that permit state and local tax planning, (4) favorable legal climates, and (5) business reasons, such as attracting investment. For large businesses with operations in many states, filing fees are typically less of a concern, and they often already have filing obligations in many states. The concerns of these businesses are outside of the scope of this post, however, the parent companies of these businesses are very often organized in Delaware.
Privacy concerns typically involve a desire to keep name(s) off of state filings and out of the public record. There are a number of reasons, both bad and good, that make privacy a concern for many business people. States vary in the amount of information required by their state filings. For example, some states, such as Delaware and Wyoming, require very little information to be disclosed on their organizational filings. In contrast, a Certificate of Formation in Texas requires the names and addresses of each governing person. For small businesses, these persons are often the same as the owners, resulting in disclosure of the names and addresses of some or all of the owners of the business. While privacy can be a legitimate reason for a foreign incorporation, some states require periodic informational reports which may negate some of these perceived advantages, by requiring periodic disclosures in addition to the organizational filings. As a result, if privacy is a major concern, foreign incorporation is often not a silver bullet, and an experienced attorney should be consulted to properly advance these interests.
Many states impose annual filing fees, franchise taxes, and other assessments on companies incorporated or registered within their state. Annual costs are low in certain states such as Wyoming, while in others, such as California, they can add up to be significant. If these costs are important to you, it sometimes makes sense to incorporate your business based upon an analysis of annual filing costs. Please see our post on “Redomiciling Your Nevada LLC to Wyoming,” which describes a situation where annual fees can play a part in choosing which state to incorporate in. With the state income tax apportionment concepts discussed above in mind, certain types of businesses, particularly those without much of a physical presence (e.g., some tech companies, licensing businesses, and investment companies) can structure their affairs in a manner to significantly reduce their state and local tax burdens. However, this type of state and local tax planning is typically quite complicated, and should not be undertaken without engaging a qualified tax attorney, accounting firm, or other tax professional.
Some states are known for having favorable legal environments for businesses. This can relate to having commonly understood laws, a well developed body of judicial precedent, and courts particularly equipped to deal with corporate law, as is the case with Delaware, or in the alternative, this can relate to a set of favorable rules in place relating to a particular industry. The former is typically why many venture capital firms and institutional investors have historically held a strong preference for investing in Delaware corporations. Delaware entities are often perceived to fit more neatly into their existing investment portfolios, as their corporate documents often have Delaware in mind, and they already have a familiarity with the Delaware legal environment. However, note that this is certainly not true for all investors, with many having no preference.
The Process for Incorporating Elsewhere
If sufficient reasons exist to incorporate in a state other than the home state, the process for doing so is not terribly difficult or expensive. As discussed in the Austin Business Advisor Entrepreneur Toolbox, the process typically involves little more than the filing of organizational documents in the foreign state, and then registration filings in other states where the business does or transacts business. While the process of foreign incorporation itself is generally fairly straight forward, the analysis behind the decision can often be quite complex, and require the services of an attorney experienced in these matters.
An attorney can help ensure the following: (1) the business is incorporated in the most favorable state; (2) the business is satisfying all of its foreign entity filing obligations; (3) the affairs of the business are arranged in the most tax-efficient manner; (4) your specific privacy concerns are being properly addressed; and (5) if seeking investment, your business is organized in a manner to make it attractive to potential investors.