When you first startup your business you’re going to get a lot of advice as to which is the best state to incorporate in.
Some of that advice will be solid. Some of it will be well-meaning, but misguided. Some of it will be wrong-headed and dangerous.
So we want to warn you. If someone tries to tell you that they know “the best state to incorporate your business in,” without first thoroughly checking the facts in your particular case, they probably don’t have a clue what they are talking about. There is no “best state of incorporation” for every situation. Like all legal issues, the best answer depends upon the specific facts.
At JGPC we work with startups and small businesses every day, and we hear the same bad advice repeated again and again. We would like to clear this one up once and for all.
There are situations in which it is best to use a foreign entity to do business in California, but they are few and seldom arise.
The Myth of Incorporating in Other States
California is the startup capital of the world. For that reason there are a lot of people out there who are marketing to California startups that their state is the best state in which to incorporate. Companies pushing Nevada entities seem to be the worst offender. Companies pushing Delaware entities are a close second. You may have seen ads trying to convince you that you should set up a Nevada corporation or a Nevada LLC.
The grass is always greener on the other side. But before you fall for the claims of these marketers, I want you to know the facts.
Setting up your business in another state is usually a big mistake. Here are three reasons why:
You will pay the same taxes if you incorporate in other states
The biggest claim you will hear is that you should set up your corporation or LLC outside of California to avoid paying California taxes. But don’t fall for it. The fact is that if you’re in California and your business is going to be in California, with rare exceptions it makes no sense to use an entity formed in another state.
That’s because no matter where you form your entity, if you’re doing business in California you will have to qualify your business in California as a “foreign entity” before you can legally do business here.
This means you will usually have to pay the same taxes as the California entities. You will pay the same minimum franchise fees and you will file the same tax returns in California as you would have had to file had you formed a California entity.
Setting up an entity in other states creates a legal mess
Setting up in Nevada can create a mess in determining which law applies.
If you form a Nevada entity then the law of Nevada will apply to a lot of issues. But many states (including California) have provisions that will subject foreign entities to the local state laws if you are operating in their state.
Regardless of where your entity is formed if you are operating in California you may be subject to California law. But by setting up your corporation or LLC in another state you have created the legal headache of figuring out which state’s law may apply in a dispute. Paying an attorney to sort this mess out for you is not a smart way to try to save money.
You will have extra corporation expenses
By going through the process of forming an entity in one state and then having to qualify it in another state you will be adding a lot of extra expense. You will have to pay two filing fees every year. You will have to file two tax returns every year. You may have to pay a lawyer or accountant to do this for you.
It will turn out to be quite a bit more expensive and usually for no benefit whatsoever. So if you are going to do business in California you may want to think twice before setting up your corporation or LLC in another state.
But isn’t Delaware the best state to incorporate in?
There is an entire cottage industry built around promoting Delaware corporations as the one-size-fits-all solution for everyone.
But the truth is that forming a Delaware Corporation would be a mistake for 99% of California startups.
Who actually should form a Delaware corporation?
It is true that Delaware has some beneficial corporate statutes for large publicly held companies. But for small closely held startups there are usually no benefits to forming a Delaware corporation.
People form Delaware corporations because there is a mythology that it is the best type of corporation to have.
We see this thinking especially among people who are looking to get funded by venture capital. This is because many venture capital companies are basically still operating in the 19th century with their view of business structures.
The only structure many of them seem comfortable with is a Delaware “C” corporation.
If you need to raise an awful lot of money – like $5 Million or more – then you will have to get that money from venture capital. There is probably nowhere else where you can find that kind of money.
If your only shot is getting funded by venture capital then you probably should think about forming a Delaware C-corporation and start your business with that. This is the entity that venture capital feels comfortable with. But that will cost you a lot more than if you started with a California corporation and then converted it to a Delaware corporation to obtain venture capital funding.
Delaware incorporation for most startups would be a huge mistake
Most Startups don’t need $5 Million to get started. If you only need $1 or $2 Million then you are going to start out way too small to interest most venture capital firms
And if you go out and form a Delaware C-corporation you’ll still need to qualify it in California, you will have to pay two state franchise fees, prepare and file two state tax returns and this will increase your cost by at least $2000-3000 per year. But you will be getting no benefit.
You will be making things more complex and expensive for no reason.
But we see it all the time. There is a whole cadre of businesses marketing Delaware corporations on the internet.
In reality it serves no purpose for most startups operating in California to use a Delaware corporation.
What if I get venture funding down the road?
You’re not locked into your entity forever. If you get venture funded down the road it is easy to make a switch.
It is usually actually cheaper to start out with a California entity and if you get to the point where you need venture funding and the venture capital firm insists on converting the entity to then switch to a Delaware Corporation. It’s not difficult to do and it’s not expensive. Or at least not usually as expensive as starting out with a foreign entity, qualifying it in California and dealing with the increased expenses of satisfying the filing and tax requirements of two states.
This article was originally published on jgpc.com.