Starting or expanding a business in the United States involves a lot of decision making. One of the early decisions involves forming a business entity. You need to quickly decide what type of business entity you will form. And just as important, you must also decide in which state you will form your entity. The type of business entity and the state in which you choose to form your entity will determine a number of things, including your tax obligations and legal protections. Because of this, deciding where to form an entity is just as strategic a decision as what kind of entity to form. This decision should be made with careful thought and consideration of the advantages and disadvantages. This article will discuss some of the important considerations you should make when determining where to form your corporation.
In the U.S., state law governs the establishment and structure of businesses, however, most states have the same general legal structures available. The most popular business entity options are: sole proprietorships, partnerships, limited liability companies, and corporations. To learn more about each of the above business entity types, review Globig’s blog series on Setting Up a U.S. Business. An attorney can help you determine what type of entity and which state is best for your business.
Setting Up A U.S. Business For International Startups Part 1: The Sole Proprietorship
Setting Up A U.S. Business For International Startups Part 2: The Partnership
Setting Up A U.S. Business For International Startups Part 3: The Corporation
Setting Up A U.S. Business For International Startups Part 4: The Limited Liability Company
Investment
If you plan to seek investment at some point, it is important to understand that many investors pay attention to where you are incorporated. Some states are more favorable than others to businesses. For many investors, where a company is incorporated plays a large role in their decision to invest in the company.
Delaware is considered one of the most business-friendly states in the country. For this reason, and their familiarity with Delaware laws, many investors prefer to work with and invest in Delaware corporations. Furthermore, some investors will only invest in Delaware companies, so it might be easier to get investment if you start out as a Delaware company. If you think you may seek investment at some point, this is a key consideration.
Legal System
Because U.S. business law is largely governed by state law, the state in which you incorporate will affect some important legal aspects of your business. Many companies prefer to incorporate in business-friendly states because of their ‘superior’ legal and court systems. Some of the aspects that make these legal systems business-friendly are faster court proceedings and dispute resolution and specialized business courts.
The primary reason why Delaware is considered a business-friendly state is because of its legal system. Delaware laws are pro-business and its courts are often more quick to resolve disputes than other states. Furthermore, Delaware has specialized business courts with experienced business judges who resolve cases rather than juries. This is a particularly important consideration for large, multi-state and multinational companies because they are more likely to face more complex business suits than smaller companies.
State Corporate Income Tax
There are several ‘tax-friendly’ states throughout the U.S. Nevada, Ohio, South Dakota, Texas, Washington, and Wyoming have no corporate income tax and Nevada, Wyoming, and South Dakota have no state personal income tax. However, Ohio, Texas, and Washington have a gross receipts tax, which is a tax on the gross company revenues. Unfortunately, many companies incorporate in one of these tax-friendly states thinking they will avoid taxes, only to learn that they will still have to pay taxes in states in which they do business.
Incorporating in one of these tax-friendly states makes sense for companies that plan to do business only in that state. But, if you plan to just incorporate in Nevada, for example, and do business in California, you may end up paying more in the long-run because you’ll have to pay all filing and annual fees to Nevada and still owe California for income you made there.
This is an important consideration for all companies because companies tend to flock to the lower tax states without understanding how taxes work and without thinking more long term about their business strategy in the U.S. and how their tax liabilities may change over time.
Formation Fees
When you form a corporation you will have to pay state filing fees. These fees vary widely by state, but range from about $50 – $500. Because this is a one-time fee, it is not generally a deciding factor for most companies.
Annual Fees and Filings
Most states have annual requirements that include the filing of an annual report with a fee. Like formation filing fees, these fees vary by state. In general the filing requirements and fees are not so arduous that they represent deterrent against any particular state.
Franchise Taxes
A franchise tax is a (usually annual) tax levied by some states on partnerships, LLCs, and corporations for the privilege of being incorporated or doing business there. Don’t let the misleading use of the term ‘franchise’ tax confuse you, a franchise tax is not a tax imposed only on franchises. Furthermore, because a franchise tax applies to companies doing business in a state, it’s important to understand that you may face franchise taxes in more than one state, even those where you are not incorporated.
Offices in Other States or Virtual Offices
It is important to understand that by incorporating in a certain state you are not obligated to have your offices there. In fact, you can have physical offices or even virtual offices wherever you determine is best for actually carrying out business. A virtual office gives you the benefit of having an address and even phone receptionist in a city and state that is good for your business, even if you are physically located somewhere else.
Foreign Corporation Doing Business In
Most states require that you file as a foreign company, which will subject you to the fees, taxes, and state regulations, if you do substantial business there. To be clear, a company is foreign to any state in which they aren’t incorporated. So if you are a Delaware company, you are foreign to all other U.S. states. As a practical matter, if you are not a large, multi-state company, it often makes sense to just register in your home state.
Moving To Another State Or Changing Entity Type
If, at some point, you want to move your corporation to another state, it may be possible. Whether this is possible and how complex it will be depends on your state laws, the laws of the state in which you intend to move, and your intentions (i.e., whether you want to incorporate in another state or just expand into another state). Generally, if you want to move your corporation to another state, you have three options:
- You can continue as a corporation in your current state and just register as a foreign company doing business in the new state. This is the simplest way to move your business, however, it will not change your state of incorporation, so if that is your intent, this is not the option for you.
- You can dissolve your corporation in your current state and form a corporation in the new state.
- You can do a company reorganization, whereby you form a corporation in the new state and merge the corporation from your current state into the new corporation.
None of these options is inexpensive and they require considerable effort, so it’s best to plan ahead and avoid moving, if possible.
Because your state of incorporation determines a number of important factors surrounding your business, it is imperative that you make an informed and well thought out decision. The consideration discussed above should be carefully weighed based on your individuals business needs. Remember, it is much easier and cheaper to get it right the first time rather than to have to move or change things later.
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