You’re starting a business in California, but should you form your company in Delaware?
Business owners often follow the lead of large companies when forming a business. Big companies have the resources to hire the best attorneys to decide where to incorporate, and these attorneys typically advise larger companies to form in Delaware. According to the Delaware Division of Corporations, more than 66% of Fortune 500 Companies and more than 80% of public companies are incorporated in Delaware. Most large and well-known companies are Delaware entities.
As a result of this popularity, many business entities are formed in Delaware. Delaware General Corporation Law is seen as being among the most flexible for the creation and protection of corporations. The Delaware Court of Chancery is known as providing a low-cost venue to settle business disputes. The State of Delaware emphasizes these advantages and openly caters its laws to the formation of entities in the state, recognizing corporate fees are a large source of revenue.
Following in the footsteps of Delaware, Nevada is another state with a reputation for catering its laws to the formation of corporate entities under its jurisdiction. Nevada has no state corporate income tax and does not require any shareholders, directors, or officers of a corporation nor members or managers of an LLC to be residents of Nevada.
Despite these advantages, typical business owners should consider the initial and ongoing costs of forming and maintaining a business in Nevada or Delaware in addition to the cost and compliance requirements in the state where their business is located. If your business conducts most or all of its activity outside of Delaware or Nevada, you’ll likely be required to register as a “foreign entity” in the state where your business is located. A “foreign entity” for the State of California is any entity formed in a state other than California. A “domestic entity” is an entity formed in California. Every state classifies companies with the same foreign or domestic entity perspective.
When must a company register as a foreign entity in California? The California Corporations Code and the California Revenue and Taxation Code require a company formed in Delaware or Nevada (or any other state) to register in California as a foreign corporation, foreign LLC, or foreign partnership if the company is seen as “doing business” in California.
The California Corporations Code provides a list of activities that do not constitute doing business in California. Despite this limited guidance, the California Revenue and Taxation Code provides more clarity. Doing business under the Revenue and Taxation Code is “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit.” This is a broad definition, but the Taxation Code provides quantitative rules to determine whether a company does business in California.
In California, a foreign entity must register with the California Secretary of State if its business activity in California exceeds the lesser of five hundred thousand dollars or 25% of the business’ total sales. The foreign entity must also register if the real and tangible personal property of the business in California exceeds the lesser of fifty thousand dollars or 25% of the business’ total real and tangible personal property.
In practical terms, California is likely to gain significant revenue from requiring the registration of foreign entities doing business in the state. Knowing this, it is reasonable to assume entities operating in, but formed outside of California, will be required to register in California because of the revenue it will bring to the state.
The process of registering a foreign company in California is very similar to forming a domestic company. Foreign company registration requires filings with the Secretary of State, a registration fee, the payment of an annual franchise tax, and ongoing compliance similar to that of a registered domestic entity.
In most cases, registering your California company in Delaware or Nevada only adds cost and complexity with no real advantages. In addition to annual fees, taxes, and ongoing compliance, your company must have a registered agent for service of process in Nevada or Delaware.
For large corporations with thousands of shareholders, Delaware is likely the best location for the company to incorporate due to the state’s laws, legal system, and experience with large and complex organizations. This is beneficial even if your business is based in another state. However, if your business is smaller, and you do not anticipate having thousands of shareholders in the near term, it is likely best to form your entity in the state where your business is located to avoid unnecessary costs and compliance.
Nevertheless, because Delaware entities (especially corporations) are often seen as providing a company an air of credibility or legitimacy, it may be wise, for presentation purposes, to register an entity in Delaware. Companies seeking investor capital may be more successful registering in Delaware if their potential investors prefer owning shares in a Delaware corporation due to the state’s favorable reputation.
In conclusion, most business owners are best served to form their entity in the state where the company is based to prevent additional fees and compliance requirements. However, there are circumstances where registration in a specific state may have its advantages, such as providing peace of mind to investors, despite the added cost and compliance.