Starting a new business is an exciting and stressful endeavor. While a new business owner visualizes boundless opportunities, he or she also confronts a seemingly endless list of decisions to make and tasks to do – product designs, marketing strategies, financing, office location, insurance, and more.
To reduce the risk of personal liability, a business owner may want to form a limited liability company, limited partnership, or corporation. Deciding how to form your business is a critical inquiry, but few business owners take time to consider another key question: where to form it. While it may seem trivial, the impact is real: choosing the right state to form your business entity can save you substantial administrative burdens, money, and time. Not to mention, it can reap tremendous rewards from a taxation standpoint.
Delaware or Bust?
The Advantages of Forming a Business in Delaware
For various reasons, many business owners choose to form their entities under Delaware State law, even if they live (and run the business) in a different state. Delaware is viewed as a business-friendly state with a well-developed body of corporate law, making it attractive to investors. Specifically, its Court of Chancery is a respected, specialized court that focuses solely on business issues. Delaware’s Secretary of State’s Office prides itself on its service and how easy it is to file formation documents on its website. Delaware also provides certain privacy protections not found in other states. Most notably, Delaware does not require an LLC to list its members or managers in its formation document or require annual filings by the LLC. The filing fees may be but are not always, less than other states.
As such, it’s not hard to see why Delaware is the leading state for publicly-traded corporations listed on U.S. stock exchanges. It is also the leading state for out-of-state incorporations, where a business based in a different state incorporates in Delaware. Nonetheless, a Delaware formation presents some challenges, especially if the business owner lives and works in another state.
Drawbacks of Forming a Business in Delaware
At the outset, filing fees can be more expensive in Delaware than in other states: Delaware charges $90.00 to form an LLC, and while it does not require annual reports from LLCs every year, it charges an annual tax of $300. Other states charge far less. For example, Mississippi only charges $50 to form an LLC and $25 to file an annual report.
The filing fees are a small matter, however, compared to some of the other potential drawbacks. Administratively, a non-resident entity formed in Delaware faces double fees and paperwork. Specifically, when a non-resident business owner forms in Delaware, he or she must register the business as a foreign entity in the owner’s home state, then register an agent for service of process (someone to accept service of a complaint in a lawsuit), in both states. This can cause substantial logistical hurdles and present potential legal pitfalls.
Further, while Delaware is a business-friendly state, a company that forms there agrees to submit to Delaware law, even regarding its internal operations and affairs. For instance, Delaware law would apply to disputes between shareholders and directors. However, Delaware law would likely not apply to disputes between employees and/or outside actors, especially if the company conducts business outside of Delaware.
A Practical Example
To illustrate, consider the example of Tim, a former mechanical engineer who opens a florist shop in North Carolina.
Tim wants to protect himself from personal liability, so he decides to form an LLC called “Dogwood Bloom, LLC.” His friend tells him all the biggest businesses in the U.S. are formed in Delaware, so Tim decides to file his Certificate of Formation online with the Delaware Secretary of State’s Office. He pays $50 to a registered agent in Delaware to accept service. Tim is impressed with how easy it is to form his LLC, and he thinks the $90 filing fee and $50 service of process payment are a small price to pay for the protection an LLC affords.
However, since Dogwood Bloom is based in North Carolina and conducts business there, Tim must also:
- Pay $250 to apply for a Certificate of Authority with the North Carolina Secretary of State (the application must contain the business name, the state of formation, the period of duration, the principal office, the officers, and the name and address of a registered agent located in North Carolina);
- Hire a registered agent for service of process in North Carolina;
- File an annual report in North Carolina for Dogwood Bloom and pay $200 for the annual report fee; and
- Pay $300 in annual taxes to the State of Delaware.
Tim would have saved himself significant administrative headaches by forming his LLC in North Carolina, where he lives and conducts 100% of his business. Tim is not planning on seeking millions in initial funding from angel investors throughout the U.S., and he is likely not going to be sued by shareholders for breaching a fiduciary duty he owed to the shareholders based on his position as an officer in the company. As such, there are few practical advantages to forming his entity in Delaware.
For small business owners like Tim, it is wise to form where you live and operate. The advantages of forming a business in Delaware will likely not outweigh the increased fees and administrative headache of forming in Delaware but operating elsewhere. Of course, this may change as the business scales. In this case, it’s advisable to reach out to one of our business formation attorneys to discuss your options.