how to select a state for company formation
There are a number of pros and cons to consider as you think about where to form or incorporate your company. In general, there is less paperwork and often slightly lower cost to incorporating in your home state--i.e., the state where your business is headquartered. However, there are significant benefits if you anticipate raising outside capital from an investor to forming your company in a company and investor friendly state like Delaware. Determining the right answer for your specific situation involves thinking through a variety of factors including filing fees, taxation, and foreign qualification issues. It is definitely possible to overanalyze the situation, since for most early-stage companies, growing the business and creating sustainable, repeatable and high-margin revenue streams are much more important goals than minimizing taxation and formation fees.
state fees
Each state will charge you filing fees when you form your company regardless of the legal structure of your business (LLC, C-Corporation, etc.). These fees can be as low as $50-60 in some states and as high as $300 in others. While it may seem tempting to simply form your company where the fees are lowest, there are a number of other factors to consider. If you incorporate in a state other than the state where your company is headquartered, you will generally have to register to do business in your home state as a "foreign" business. This simply means that because you are not headquartered in your home state, that state will view your business as an outside company seeking to do business in the state. States generally require that your qualify to do business as a foreign company. This "foreign qualification" will require a filing with the state which will then generally subject your company to taxation and fees from the state. You can find a complete list of fees by state here.
Taxation
Taxation can differ significantly by corporate type and by state. Generally, how relevant these taxation issues become depends on how much money you think your company will make, how large your company will become, whether you plan to lose a lot of money for several years before making a lot of money, or whether you plan on granting dividends from a cash-flowing business.
C- Corporations
Corporations are taxed at a corporate tax rate. Legally they are state-based, independent, legal "entities" that are separate from their shareholders and officers (managers). You can find the various state taxation rates for corporations here. To get the total tax rate, you will need to combine that data with total federal tax rates displayed here.
S-Corporations
S-Corporations are pass-through tax entities, which means that they do not generally pay significant taxes at the company level on business income. Rather S-Corporations pass the income that they create on to their owners and these owners are passed at their own personal tax rates. In some states, other taxes apply to S-Corporations.
LLCs
LLCs are also pass-through tax entities, which means that LLCs do not necessarily pay a tax at the company level on business income. LLCs pass the income that they create on to their owners and these owners are taxed at their own personal income tax rate. For single-owner LLCs, the owner must report all profits (or losses) on Schedule C and submit it with a 1040 tax return. For multi-owner LLCs, owners (or members) are taxed on their "distributive share" of income. "Distributive share" is the term used for one owners share of the income of the LLC. For the vast majority of LLCs, distributive shares are direclty proportional to their ownership in the LLC which is generally spelled out in the LLCs Operating Agreement. LLCs must file a form 1065 with the IRS, though they are not taxed as business entities. The LLC must also provide each member with a Schedule K-1 which becomes part of the individual member's 1040 as Schedule E. Because LLC members are considered self-employed, they must estimate the amount of tax they will owe and make quarterly payments to the IRS. Because the IRS generally considers LLC members as self-employed (there are some exceptions), LLC members must also generally pay self-employment tax, which was most recently 15.2% of the first $106,800 of income, and 2.9% of everything above that. In addition to these general facts, keep in mind the following notable facts:
- Some state do charge LLCs a tax based on how much income they generate. For example, California taxes LLCs that make more than $250,000 / year. These taxes generally range from $900 to $11,000.
- Additionally, some states charge LLC an annual tax, often called a "franchise tax." These fees can range from $100 in many states to $800 for California.
Foreign Qualification or Registering to do business in another state
States will often require a that business that is headquartered out-of-state but doing business in the state file a foreign qualification--basically a registration to do business in that state. These fees generally are between $50-200. Often these fees are determined and collected at the municipal level not at the state level. The definition for "doing business" in a state can vary in each state. Often you can do some business without having to register and you may only need to register when you start doing a significant amount of business in the state or you open an office there.
Advantages of Nevada and Delaware
Delaware and Nevada are two states in which some entrepreneurs frequently opt to incorporate. They offer unique advantages for certain types of businesses.
Some potential advantages of incorporating your business in Delaware include:
- Delaware’s business law is one of the most flexible in the country.
- The Court of Chancery focuses solely on business law and uses judges instead of juries.
- For corporations, there is no state corporate income tax for companies that are formed in Delaware but do not transact business there (but there is a franchise tax).
- Taxation requirements are often favorable to companies with complex capitalization structures and/or a large number of authorized shares of stock.
- There is no personal income tax for non-residents.
- Delaware does not require director or officer names (corporations) or member/manager names (LLCs) to be listed in formation documents, allowing for some additional privacy.
- Shareholders, directors and officers of a corporation or members or managers of an LLC don’t need to be residents of Delaware.
- Stock shares owned by persons outside Delaware are not subject to Delaware taxes.
- For all of these reasons, Delaware companies are the preferred option for sophisticated, institutional investors like venture capitalists and many angels
- Some potential advantages to forming a corporation or LLC in Nevada include:
Nevada has no state corporate income tax and imposes no fees on corporate shares.
- There is no personal income tax or any franchise tax for corporations or LLCs (but initial and annual statement fees and business license fees apply).
- Shareholders, directors and officers of a corporation or members or managers of an LLC don’t need to be residents of Nevada.
Decision Framework
Given the complexity involved in making a decision, we recommend that you first decide on what corporate type you want to form. Based on that decision the conventional wsidom is that you should either 1) incorporate in the same state where your company is headquartered, i.e., your "home" state or 2) incorporate in a company-friendly jurisdiction like Delaware. The latter is generally a requirement for institutional investors like venture capitalists and caters to companies who really want to ultimately grow out of being a small business. Given these facts, we have put together a decision framework for you that contrasts the costs and benefits of each option.
Framework for Deciding Formation State
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Home State |
Company-Friendly Formation State like Delaware |
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Costs |
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State Formation Fees |
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Taxation |
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Registering to Do Business (Foreign Qualification) |
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Total Direct Costs |
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Benefits |
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