Forming a new Limited Liability Company is exciting. It can mean the start of a new idea, a new dream, or just a new way of doing business better than before. Forming a new LLC for an online entity is just a small step on what should be a long run of doing business, but some entrepreneurs make a big decision by choosing a specific state with little to no grounds for their choice. Why is so little thought put into choice of venue when the new LLC could be formed in any one of a variety of states?
If you are forming a traditional, brick and mortar business, the state where you have that physical presence is probably the best choice to form your LLC, but when you are planning to build an online business or need a US outpost for a foreign company there may be many choices. Some of the most common choices are not the right choices, showing no effort or consideration of the facts and individual circumstances of the business. I have been amazed at how many new companies are formed in Delaware without any real reason to be formed in Delaware. Don’t get me wrong — because of its body of business law and separate business court system, Delaware is probably the best state to incorporate a stock company. Companies that decide to go public often move their places of incorporation to Delaware as part of the IPO process, and it is the place to be for large, public stock companies. However, for virtual businesses or others that can locate just about anywhere, Delaware makes little sense.
Delaware Court of Chancery, or “Business Court”
Delaware has two big things going for it as a state of incorporation: 1) Delaware is the state publicly traded stock corporations choose because of a body of business law that makes Delaware a good state for stock corporations and 2) Delaware has a separate business court, known as the Delaware Court of Chancery, that provides a unique and predictable court system for the internal affairs of big businesses, recognized worldwide for its fairness and expertise settling corporate issues. However, the Delaware business court system is only a benefit if you plan to use it. Publicly held stock companies need a predictable court system for governance affairs and the business court in Delaware is that system, which is why Delaware is a good choice for big, publicly held stock companies. It holds little value for small, privately held Limited Liability Companies. When you are ready to form your new company, ask yourself: 1) Do I plan on needing to go to court regarding my business organization on a regular basis? 2) Do I have a Delaware-licensed attorney that can represent me in Delaware if I am sued or need to file suit? If you answer “no” to those questions, what advantage does the Delaware business court give you? If you are like most small businesses, your answer is “nothing,” and most likely, choosing Delaware for your LLC makes your life more difficult if you end up in court. If you are told to form a company in Delaware and given its business court as one of the reasons to do so, ask your advisor to elaborate on that and explain why the Delaware business court system is an advantage and when you can expect to make use of it. In real life if someone decides to sue your new business for something, do you want to defend yourself in Delaware? Have you tried to find a Delaware attorney? If you are creating an adult-oriented business, have you tried to find a Delaware licensed attorney that accepts adult clients? At the time of this writing, out-of-state attorneys can be admitted pro hac vice (special admission that is specific to your case) to represent a client in a Delaware court for a fee of $407 per case, but must have a Delaware-licensed attorney sponsor, so the attorney you normally use would still need to find a local sponsor before defending you. The court rules require the Delaware-licensed sponsor attorney to be present at all court proceedings and sign all the filings, so the Delaware attorney must be intimately involved, usually by the billable hour, in every part of your case. That means you are going to pay a Delaware-licensed attorney and your adult-entertainment attorney for every court appearance and every filing. The rules were written by Delaware attorneys, for Delaware attorneys, and to benefit Delaware attorneys. You will likely pay two attorneys for everything if you are haled into court in Delaware. If you want to create a new company, you have to be prepared to defend that company, and Delaware is probably not the place you want to find yourself as a defendant.
Costs over the Long Run
The next negative factors with Delaware LLC’s are the annual filings and fees required to maintain them in good standing. Delaware currently has a hefty $300 annual fee, in addition to maintaining a Registered Agent and filing annual reports. Over 5 years, that’s $1500 or more in filing fees just to have an active LLC and doing nothing for your bottom line. By comparison, there are currently no annual fees at all for Arizona, Idaho, Mississippi, Missouri, New Mexico, Ohio, South Carolina, or Texas LLC’s, and no annual report or filings for Arizona, Missouri, New Mexico, Ohio, and sometimes South Carolina. Here’s a list of annual LLC fees and filing requirements by state for comparison purposes:
Like all parts of your business, the cost of maintenance of your LLC over the course of years should be taken into account before diving in. The differences will add up.
All states levy taxes of some kind to raise revenue and support expenditures. States generally utilize some combination of excise taxes, income taxes, property taxes, and sales taxes, with significant differences in allocations but all raising billions. Some states are celebrated for having no income tax, although every state with no income tax typically has relatively higher sales or property taxes to make up for it, which is less well known. There is no such thing as a state with no tax because there is no such thing as a state with no budget, and that money must come from somewhere. A state with no income tax has higher taxes on other things to fund its expenditures, so you cannot make an apples-to-apples comparison simply by looking at the income tax rates. It is important to consider the total tax burden on your business activities, not just income tax, when comparing states for business locations.
Because of the absence of state income tax in various states, erroneous recommendations are made based on that alone. It is foolish to blindly accept someone telling you Nevada/Wyoming/Texas/etc. is a good state to form an LLC “because there is no income tax.” That is an all-too-common mistake that belies a lack of understanding of LLC taxation. Most LLC’s are pass-through tax entities, so their income is not taxed at the LLC level but instead passes through to the owner, who then pays taxes on the income at the owner’s rate, in the owner’s jurisdiction. If you are going to form a pass-through LLC for an online company and don’t plan to have a physical office, for the purposes of taxation it doesn’t matter if your LLC is formed in Texas or Tennessee — the income isn’t taxed at the LLC level, it’s taxed at the owner-of-the-LLC level. Consult with your tax advisor because this can depend on specific circumstances, but don’t buy the “no state income tax” as a selling point for LLC location.
If you do not plan to have a physical office, there are many options for locating your new Limited Liability Company. Delaware and Nevada always come up when I talk to someone about forming a new LLC, and rarely are either of those states a good choice. Consult with a professional about annual fees, maintenance costs, taxation, and the practical effects of forming a new LLC in various states before making a decision that could come back to haunt you. If your chosen professional does not ask you a lot of questions about how you intend to operate your business before telling you to form a Delaware or Nevada LLC, find someone who will.
Chad Anderson is an accountant and attorney licensed to practice in Arizona, Nevada, and Iowa.
The preceding is not legal advice, and no attorney-client relationship is created by reading or adopting the opinions of the author. Consult with your licensed legal or tax advisor.