One of the most common questions I get is “In which state should I form my business?” As with most questions, the answer is typically “it depends.” However, the answer does not depend on what most new business owners think. In fact, for many, the answer is pretty simple.
If you read business publications or have taken a college business course, you have likely heard about the Delaware corporation. We all learn that corporations love to form in Delaware. States like Nevada and Wyoming also have many business filings.
Businesses are governed by the rules of the state in which they are formed. However, the more important, and often overlooked, truth is that businesses are also governed by the laws of the states in which they operate. This is why my first question I always ask new business owners is “Where do you plan to operate your business?”
You may be asking “Why then would so many businesses wish to form in Delaware?” Delaware has laws that are pro-business. The state has its own courts that hear business disputes where cases are heard by judges rather than by juries. Juries tend to be great for the little guy, while bench trials (those decided by a judge) tend to render verdicts more favorable to larger businesses as a judge will be less likely to allow sympathy for the plaintiff to cloud her judgment based on the law.
While differences in state business law are very beneficial to large corporations, smaller businesses need not put as much energy and money into business disputes. Typically, an LLC or Corporate formation along with liability insurance should assuage any dispute concerns.
So if the Delaware Corporation isn’t the magical business entity unicorn it’s always made out to be, where should you form your business?
The answer, in most cases, is wherever you plan to operate. Here’s why.
You will pay income taxes to the state in which your business earns its income. In addition, many states also have an annual franchise tax. In CA, that tax for LLCs is $800. Many states also require “foreign LLCs” (LLCs formed in other states) to pay the state franchise tax if they are doing business in that state. A business “does business” in CA if it is based in CA. If the business is not based in CA, there are numerical metrics based on sales that determine whether the business is doing business in the state.
What does this all mean? If you have an LLC formed in Delaware that you operate in California, you will still pay all the same state income taxes that you would have you formed in CA. You will also pay the CA state franchise tax since the business would be considered a foreign LLC. The only difference is that now you also have to meet whatever state fees, taxes, and requirements Delaware might have. In short, forming in state where you don’t operate is going to cost you more money and more time without providing much, if any, benefit.
When should you consider forming in one of the pro biz states?
If you plan to operate in multiple states, sell products nationally, or form a U.S. business but live or work abroad, there are important considerations to make. If you fall into one of those categories, you will want to seek the help of an attorney to make the right choice.
Choosing a business entity is a very important decision. You need to decide not only where to file but which type of entity to form. I explain, in detail, the differences between entities and the considerations you should make in Phase 2 of the Small Biz Start Up Guide. You can now grab a copy of each stand along chapter. If you want more info on biz entities, you can get Phase 2 here.
All you need to know about opening an operating account and setting up your small business legal matters is covered in the Small Biz Start Up Guide!