“You should incorporate your business in Delaware. You’ll save a ton of money.”
If you’re an entrepreneur starting a new business, chances are that someone you know shared that advice (or something similar) with you. On the surface, it sounds like a great idea. Certain states, particularly Delaware and Nevada, are noted for being exceptionally friendly to business, particularly when it comes to paying business taxes.
However, before you decide to incorporate outside of your home state, there are a few important points that you need to consider. If you don’t read the fine print and know exactly what you’re getting into, you could wind up spending more money than you would have if you’d just incorporated closer to home.
The Basics of Incorporation
Incorporation essentially means that you change your business from a private entity, owned by an individual or partnership, to a company with a structure and assets that are separate from those owners. Doing so protects the owners from liability should something go wrong with the company; in most cases, when the company is incorporated, the owners are only liable for the amount of money that they personally invested in the company, and their personal assets are protected and can’t be used to pay debts incurred by the company.
Most entrepreneurs incorporate as an LLC, a C-Corp, or an S-Corp. Each type of incorporation offers its own advantages and disadvantages, and has its own set of requirements and rules. However, there’s no rule that says you have to incorporate in your home state, or even the state where you do most of your business. Hence the trend for many companies to choose the state that they feel offers the most advantages to them, regulation and tax-wise.
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Why Small Businesses May Not Benefit From Out-of-State Incorporation
The business-friendly laws of states like Nevada and Delaware are just one of the reasons that most Fortune 500 companies are incorporated there. The real reason so many companies do so, though, is that Wall Street rules often require them to do so. Companies that have thousands of shareholders have to comply with complex securities laws, and states like Delaware make it much easier for them to do so. And of course, one cannot overlook the tax benefits of such structures; the lack of business taxes on most companies incorporated in those states can save large companies millions of dollars each year.
However, for a small business, the benefits of out-of state incorporation aren’t so obvious — or even applicable. After all, if you don’t have shareholders, what difference does it make if shares are taxed or not in your home state?
There are a few other issues that many business owners fail to realize when they are tempted to incorporate out-of-state:
You Still Have to Pay Taxes. One of the major selling points that those in favor of Delaware or Nevada incorporation often use to convince entrepreneurs is that “Your business won’t pay taxes.” This is just plain incorrect, and misleading. In some cases, yes, incorporating in certain states protects a business from having to pay certain income or franchise taxes.
But even then, you aren’t immune to paying any taxes. Your business is still on the hook for federal taxes, regardless of where you incorporate. And even if your business is incorporated on the other side of the country, you’ll have to pay business and personal income taxes in your home state if you do business there; in fact, you’ll have to pay taxes on our profits in any state where you do business that has a state income tax.
You Pay More in Administrative Costs. It’s not free to incorporate a business, and you have to pay filing and licensing fees no matter where you choose to incorporate. In addition, you may also need to register as a “foreign entity” in your own state, since that’s where you’ll be doing business, increasing costs and the complexity of managing taxes and licenses.
You’re Not Protected From Liability. While incorporating your business provides protection against personal liability for business debts, that protection only applies if you are registered in the state where you are doing business. In other words, if your business is registered in Nevada, you are only protected from liability in Nevada, which won’t help you very much if your business is in Illinois.
There are times when incorporating in another state is advantageous to your business or even necessary. However, for most small businesses, the best plan is to incorporate where you are located and/or where you will be doing business. You will save yourself major headaches, while saving money you can invest back into your business.
