Many small business owners choose to operate their businesses as either a corporation, such as a C Corporation or S Corporation, or a limited liability company to limit their personal liability.
Choosing the state in which to form a business is also an important consideration. Another factor to consider is which state is the most suitable for establishing that business entity.
In this article, we explore key considerations when choosing a formation state for your business entity.
What is a state of formation?
A state of formation is the state where you submit your business formation documents. This state is governed by its corporation or LLC statutes (laws), which will apply to your corporation or LLC. It is also known as the state of organization, domestic state, or home state.
You can form a corporation or limited liability company (LLC) in any state, even in a state in which you conduct no business activities. When an out-of-state entity is created, there is no requirement that any assets be located in that state.
No matter which state you select, you are required to file articles of organization with the relevant state agency. As part of this process, you must appoint a registered agent in that state who will accept legal documents on behalf of your business, thereby consenting to the state's jurisdiction. This formation paperwork is usually filed with the Secretary of State's office.
Furthermore, if your company conducts business outside of its state of formation or incorporation, you must register in all the states where you operate. This process is referred to as "foreign qualification". This may sound daunting, but in nearly all cases, it simply requires filling out a basic form and paying a fee to the Secretary of State.
In summary, you have two options for choosing a state of formation:
1) Form the entity in your home state; or,
2) Form the business in another state.
There are advantages and disadvantages to either option, and you should consider the complexity of administration, fees, and costs. From an asset protection perspective, also consider the advantages of forming and registering a business in a state that is favorable to business ownership.
Advantages of forming an entity in your home state
When choosing the state in which to form your business entity, the simplest option is to form the entity in your home state, where, typically, all of the business activities will be conducted.
Creating an entity in another state can lead to additional costs. When you form an out-of-state entity, you must also register it to conduct business in your home state. This process involves paying fees in both the state where the entity is created and in your home state, resulting in two sets of expenses. In contrast, if you form the entity in your home state, you only pay one set of fees. Additionally, if you plan to do business in other states, you may need to register in those states as well.
However, from an asset protection perspective, these extra fees may be worth the cost. The laws of some states are considered more business-friendly than others and may afford you more protection for your business and assets. In this way, the extra costs are like paying for extra liability protection.
Registration is required in each state with substantial business activity
You must register your business entity as a "foreign" entity in each state where you do substantial business. The activities of a holding entity usually do not rise to the level of "doing business" in a state. Thus, normally, an out-of-state holding entity would not have to register in the owner's home state or where the operating entity conducts the business's operations.
It is important to distinguish between failing to register as a foreign entity and failing to file articles of organization. The consequences of not registering as a foreign entity can differ from state to state. For instance, in some states, the entity may be prohibited from seeking legal or equitable relief in state courts.
Failure to register a business does not stop others from taking legal action against it. In some states, there are civil penalties for not registering, while other states simply require the entity to pay the overdue registration fee.
Some states may have more harmful consequences by failing to recognize a business entity. This can lead to unlimited personal liability for any debts the business incurs in that state or even invalidate the business's contracts. If you're unsure, it’s best to register your business or seek advice from an attorney.
Note: The entity-within-an-entity concept, which was first introduced in the Delaware LLC statute, can eliminate this problem. A single LLC can house multiple separate legal entities. For example, a single LLC can be formed in Delaware and then register in any state in which the operating entities will do business. The laws governing Series LLCs vary significantly among states. Not all states permit the formation of Series LLCs. Furthermore, some states may recognize Series LLCs established in other states, even if they do not allow their own formation.
Factors to consider when selecting a formation state
Some of the factors to evaluate when selecting a state of formation are
- Fees
- Protection of business assets against personal creditors
- Full-shield liability protection
- Management flexibility and simplicity
- Asset protection trusts
- Tax incentives
State fees are only one factor to consider
When choosing a state to establish your business, opting for the cheapest option may not necessarily be the best decision. Consider the following scenarios:
Forming your business in another state (but conducting business in your home state): A lower formation fee in another state should not be the sole reason for forming your business there, especially if you plan to operate primarily in your home state. If you plan to conduct business in your home state, you must pay a registration fee, which is equivalent to a formation fee, there.
- Conducting business solely in another state: If you are conducting business only in another state and not in your home state, you should consider forming your business entity in the state where you will be operating. This approach will result in having to pay only one registration fee.
Consider this scenario:John is a Massachusetts resident who plans on doing business exclusively in Connecticut. If he decides to form a corporation in Massachusetts, his home state, he will pay a formation fee to the state of Massachusetts and a foreign registration fee to the state of Connecticut. John's best choice may be to form a corporation in Connecticut and pay only the Connecticut formation fee.
- Doing business across state lines: If your company conducts business across state lines, or outside your state of formation, you may need to go through the process of a foreign qualification, including selecting a registered agent. At this point, state fees sometimes become a consideration.
State fees to form an LLC are often lower than those charged to form a corporation. However, this is not always the case, particularly as states look for new forms of revenue. For example, in Nevada, one of the key states for business formation, the fees charged by the state are the same for forming a corporation and an LLC. And, some states charge significantly higher fees for forming and renewing an LLC than for a corporation.
- Forming a corporation: If you live in one of the states that charge higher fees for forming and renewing an LLC than a corporation, you may want to consider forming a corporation, rather than an LLC, at least where fees are an important deciding factor. However, the fee savings may be misleading! In general, a corporation will end up costing you more money because it may be subject to state corporate income tax, as well as annual assessments (franchise tax) based on the number of authorized shares and annual reporting fees.
If you plan to form a corporation, it is usually advisable to establish it as a statutory close corporation. However, this type of corporation is not legally recognized in some states that impose high fees for LLCs. Therefore, the cost of forming a statutory close corporation in another state, along with the fee for registering that corporation in your home state or wherever it will conduct business, is likely to be comparable to the fees charged by your home state for forming an LLC.
Some states impose "publication fees"
While other factors may be more important than the fees charged, it is important to note the publication fees that corporations and LLCs may be required to pay in several states.
- LLCs. New York, Nebraska, and Arizona require LLCs to publish the information from their articles of organization in a newspaper. For example, in New York, this information must be published once per week, for a total of six weeks, in two different newspapers. This can cost anywhere from $600 to $2,000 (not including the filing fee for the certificate of publication with the state). This may make the LLC a cost-prohibitive option in these states. Similarly, any out-of-state LLC that will be doing business in one of these states must satisfy the same publication requirements, with information from its registration. This cost can be expected to be in the same range, as described above.
- Corporations. Note that four states, Arizona, Georgia, Nebraska, and Pennsylvania, require that corporations publish the information regarding the articles of incorporation.
Creditors' rights are factors
When selecting a formation state for your business entity, it's important to consider more than just simplicity and the immediate out-of-pocket costs for state fees. The internal affairs — such as voting, management, and other governance issues—as well as the liability of the owners in an LLC or corporation, are determined by the state in which the business is formed, rather than the state where it operates. Keep in mind that laws vary from state to state.
Some states offer significantly greater asset protection and other benefits as well. In fact, some states (such as Delaware and Nevada) have a reputation for developing a body of law and a court system that are often viewed as favorable to businesses.
As a result, you should give careful consideration — and seek input from a professional — when forming your business entity in one of these states. This is especially true if your home state is deficient from an asset protection perspective.
Some states have restrictions on PLLCs and LLPs
California prevents professionals such as doctors and dentists from operating in the LLC form. California also limits its limited liability partnerships (LLPs) to a narrow class of professionals, namely lawyers, architects, and accountants. New York also limits LLPs to professionals but defines this term more broadly than California. If you are a professional and plan to form an LLC or an LLP and do business in California or New York, caution must be exercised.
If an entity cannot be formed in certain states, it may not be recognized if it is formed in a different state and then attempts to register to do business in those states. As a result, the business could only be recognized as a sole proprietorship or a general partnership, which provides very limited asset protection.
Evaluate state law protection for business interests against personal creditors
Some states do not offer enough protection for a business owner's interests in an LLC when it comes to claims from the owner's personal creditors. These states model their LLC statute's charging order remedy on the general partnership provision that allows for foreclosure of the interest and forced liquidation of the business.
Many states, including Delaware and Nevada, protect the business interest. These states model their LLC statutes on the charging order concept found in the Revised Uniform Limited Partnership Act (RULPA). If your home state does not offer this business interest protection, you might want to consider forming an LLC in a state that does offer such protection.
Full-shield limited liability protection is ideal
Some states offer only a limited shield (i.e., a stripped-down version) of limited liability for the owners of LLPs. In particular, the limited shield means that the owners of an LLP will have limited liability only with respect to the actions of their co-owners; the owners will still have unlimited, personal liability in all other cases.
If the home state only offers this limited-shield version, and an LLP is the type of entity that will be formed, consider forming the LLP in a state, like Delaware and Nevada, that offers full-shield protection.
Evaluate for management flexibility
Some states require that all members of an LLC can vote on certain issues, even if the LLC is managed by a small group called "managers." This can create confusion and make some votes invalid. It can also disrupt estate planning strategies, like using a family LLC where children have nonvoting shares.
In some states, LLC laws state that the operating agreement can say members have no voting rights or limit their voting rights to specific matters. Delaware is one of those states. If members in a home state have mandatory voting rights, it may be worth considering forming the LLC in Delaware or another state that allows owners to completely remove voting rights for some members. Additionally, Delaware's LLC laws may offer better protection if one of the members goes bankrupt.
Consider states that allow series LLCs
Delaware law allows for series LLCs, which means one LLC can have multiple divisions. This law offers great flexibility and ease in forming and running an LLC, unlike laws for corporations or LLCs in other states.
You can create separate entities within one LLC, which means you don’t need to set up a different LLC or corporation for each part of your business. Each division can manage its own finances, own assets, and only be responsible for its own debts, similar to separate LLCs. Therefore, a single LLC can effectively manage both the main holding entity and various operating divisions.
Know state tax ramifications for entity selection
Typically, an LLC and a Subchapter S corporation do not pay state income taxes in a state where they do not do business and where the owners do not live. This can make it attractive to form the business in another state. However, the owners will need to pay state income taxes in the state where they live or in the state where the business operates, which is usually but not always the same state.
Most states treat LLCs as pass-through entities for tax purposes, similar to how they treat corporations that choose to be taxed under subchapter S. However, a few states do not recognize this subchapter S election. In these states, a corporation may face state income taxes even if it does not operate there. Additionally, some states might consider an LLC as a corporation for tax purposes and impose taxes on it, regardless of whether it conducts business in the state.
Although these situations are unlikely to be encountered, it's a good practice to check with state taxing authorities before choosing a state in which to form your business — or form your business in a state such as Delaware or Nevada, which provides clear rules that can be favorable to the small business owner.
Look for a business-friendly state
While every state allows you to form a corporation or an LLC, not all offer some of the newer, more effective asset protection and business management entity types, such as a statutory close corporation or a domestic asset protection trust.
Asset protection trust options exist in a few states
Forming the holding entity in certain states can be part of an overall asset protection plan because these states have statutes authorizing the creation of domestic asset protection trusts. In the states of Alaska, Delaware, Hawaii, Missouri, Nevada, New Hampshire, Ohio, Oklahoma, Rhode Island, South Dakota, Tennessee, Utah, Virginia, and Wyoming, domestic asset protection trusts are allowed by law.