ComplianceLegalFinanceNovember 21, 2019

Key issues in selecting formation state

Limiting liability in your business structure involves choosing the best organizational form. However, selecting the state in which to form the business is also a significant consideration.

Many small business owners choose to operate their business as either a corporation (C Corporation or S Corporation, for example) or a limited liability company in order to limit their personal liability for business debts. An additional factor to consider is which state is the best one in which to form that business entity. 

You can form a corporation or limited liability company (LLC) in any state, even in a state in which you conduct no business activities. Further, even when an out-of-state entity is created, there is no requirement that any assets be located in that state.

Regardless of the state you choose, you must file articles of organization with the appropriate agency for that state. As part of this process, you must designate a registered agent within that state that will accept service of process (i.e., for purposes of consenting to the state's jurisdiction.) This formation paperwork is usually filed with the Secretary of State's office. A fee is required at the time of the filing.

Failure to file means the entity does not exist, and the owner is operating a sole proprietorship or a general partnership. This can spell disaster if your business experiences financial difficulties or if you experience personal financial issues because all of your assets are at risk.

In addition, if your company does business outside of the state of formation or incorporation, you must properly register in all the states in which you do business. This process is referred to as "foreign qualification." This may sound daunting, but in nearly all cases it simply requires filling out a very simple form and paying a fee to the Secretary of State.

Thus, you have two options: form the entity in your home state or form the business in another state. There are advantages and disadvantages to either option and among the considerations are the complexity of administration, fees, and costs. From an asset protection standpoint, you'll want to consider the benefits of forming and registering in a state known as friendly to business ownership. Any additional expenditure of time and money may be inexpensive compared to the unique protections some states offer.

Advantages entity formation in your home state

When choosing the state in which to form your business entity, the simplest option for the small business owner is to form the entity in his or her home state, where, typically, all of the business activities will be conducted.

Forming an entity out-of-state will create additional costs. The out-of-state entity will have to register to do business in your home state. Thus, you must pay two sets of fees to form the entity out-of-state, but only one fee if the entity were formed in the owner's home state. (If you are going to do business in other states, you may need to registration in those states in any event.) However, from an asset protection perspective, these extra fees may be worth the cost. Some states' laws are considered more business-friendly than others and may afford you more protection for your business and assets. In this way, the extra costs are like paying for extra liability protection.

Registration required in each state with substantial business activity

You must register your business entity as a "foreign" entity in each other state in which you do substantial business. The activities of a holding entity usually do not rise to the level of "doing business" in a state. Thus, normally, an out-of-state holding entity would not have to register in either the owner's home state or where the operating entity conducts the business's operations.

Failure to register in this regard should be distinguished from failure to file articles of organization. The consequences of a failure to register as a foreign entity in a state vary from state to state. For example, the entity may be barred from pursuing legal or equitable relief in state courts. 

On the other hand, failure to register will not prevent others from bringing legal actions against the corporation. Some states impose civil penalties for failure to register. And, some states simply provide that the entity must pay the registration fee that was due.

However, a few states might provide for far more insidious results, by not recognizing the entity, which would result in unlimited personal liability for the business's debts incurred in that state, or invalidation of the business's contracts. When in doubt, register--or consult an attorney for advice.

Note that the entity-within-an-entity concept, which is embodied in the Delaware limited liability company (LLC) statute, eliminates this problem. A single LLC can house multiple separate legal entities. This single LLC is formed in Delaware and then registers in any state in which the operating entities will do business.

Holding entities need register only in formation state

Holding entities need to register only in the formation state. If two entities are being formed (a holding entity and an operating entity), there will be no additional costs involved in forming an entity out-of-state. The holding entity could be formed out-of-state, and the operating entity in the owner's home state.

Because the holding entity will conduct no business activities in the home state, it needn't be registered in the home state. Specifically, the activities of the out-of-state holding entity should not rise to the level of "doing business" in the home state. Thus, the cost of forming two entities, with one formed out-of-state, will be the same as forming both entities in the owner's home state.

Factors to consider when selecting formation

Some of the factors to evaluate when selecting a state of formation are

  • fees involved;
  • protection of business assets against personal creditors;
  • full-shield liability protection;
  • management flexibility and simplicity;
  • statutory close corporation option;
  • asset protection trusts;
  • tax incentives; and
  • exemption from securities registration.

State fees are only one factor to consider

When choosing a state in which to form your business, the simplest (or cheapest) choice may not be the best choice. Another state's lower formation fee should not be the deciding factor in forming the entity there when the owner will be doing business in his own home state as well.

Clearly, the small business owner cannot avoid his home state's fee by forming an out-of-state entity, because a registration fee, equivalent to a formation fee, must be paid to the owner's home state anyway, if the owner will be doing business there. 

However, if you are doing business in another state, but not in your home state, and you intend to use only one entity, you should consider forming the entity in the state in which you will be doing business, rather than your home state. This will result in only one fee.

John is a Massachusetts resident who plans on doing business exclusively in Connecticut. If he decides to form a corporation in Massachusetts, his home state, he will pay a formation fee of $275 to the state of Massachusetts and a foreign registration fee of $385 to the state of Connecticut. John's best choice may be to form a corporation in Connecticut and pay only the Connecticut formation fee of $100.

If your company conducts business across state lines, or outside your state of formation, you may need to go through the process of a foreign qualification, including the selection of a registered agent. At this point, state fees sometimes become a consideration.

State fees to form an LLC are often lower than the fees charged to form a corporation. However, this is not always the case, particularly as states look for new forms of revenue. For example, in Nevada, one of the key states for business formation, the fees charged by the state are the same for the formation of a corporation and an LLC. And, some states charge significantly higher fees for forming and renewing an LLC than for a corporation.

If you live in one of the states that charge higher fees for forming and renewing an LLC than a corporation, you may want to consider forming a corporation, rather than an LLC, at least where fees are an important deciding factor. However, the fee savings may be misleading! In general, a corporation will end up costing you more money because it may be subject to state corporate income tax, as well as annual assessments (franchise tax) based on the number of authorized shares and annual reporting fees.

The small business owner intending on forming a corporation should usually form it as a statutory close corporation. However, this form is not legally recognized in some other states that charge high LLC fees. So, the fee for forming the statutory close corporation out of state, plus the fee for registering the corporation in the home state or wherever it will be doing business, will probably be equivalent to the fee charged by the home state for an LLC there.

Some states impose "publication fees." While the small business owner should consider that other factors may, in fact, be more important than the relative fees charged, nevertheless, special note should be made of publication fees that may be required of corporations and LLC in several states.

  • LLCs. New York, Nebraska, and Arizona require that an LLC publish the information from its articles of organization in a newspaper. For example, in New York, this information must be published once per week, for a total of six weeks, in two different newspapers. This can cost anywhere from $1,000 to $2,000, and this may make the LLC a cost-prohibitive option in these states. Similarly, any out-of-state LLC that will be doing business in one of these states must satisfy the same publication requirements, with information from its registration. This cost can be expected to be in the same range, as described above.
  • Corporations. Note that four states, Arizona, Georgia, Nebraska, and Pennsylvania, require that corporations publish the information in the articles of incorporation. Thus, the publication fees are not a factor in Arizona and Nebraska.

Creditors' rights are factors

When choosing a formation state for your business entity, simplicity and immediate out-of-pocket costs for state fees should not always be the main considerations. The internal affairs (voting, management, etc.) and the liability of the owners for a limited liability company (LLC) or corporation are governed by the state where the business is formed, and not the state where it does business. The laws in each state are not all the same. 

Some states offer significantly greater asset protection and other benefits as well. In fact, some states (such as Delaware and Nevada) have a reputation for developing a body of law and a court system favorable to the business owner.

As a result, you should give careful consideration--and seek input from a professional--to forming your business entity in one of these states. This is especially true if your home state is deficient from an asset protection perspective.

A business entity's internal matters (voting, management, etc) and liability status will be governed by the state in which it is formed. However, nothing requires a state to recognize a type of entity that cannot be legally formed there.

California prevents professionals from operating in the LLC form. California also limits its limited liability partnerships (LLPs) to a narrow class of professionals, namely lawyers, architects, and accountants. New York also limits LLPs to professionals but defines this term more broadly than California. Thus, in the case of professionals who form an LLC or an LLP, and plan on doing business in California or New York, caution must be exercised. 

If the entity could not be formed in those states, it also will not be recognized if it is formed in another state, and then seeks to register to do business in those states. The end result could be that the business will be recognized only as a sole proprietorship or general partnership with very limited asset protection available.

Evaluate state law protection for business interests against personal creditors. Some states do not offer adequate protection for the owner's business interest in a limited liability company (LLC) against the claims of the owner's personal creditors. These states model their LLC statute's charging order remedy on the general partnership provision that allows for foreclosure of the interest and forced liquidation of the business.

Many states, including Delaware and Nevada, offer protection for the business interest. These states model their LLC statutes on the charging order concept found in the Revised Uniform Limited Partnership Act (RULPA). If the business owner's home state does not offer this business interest protection, serious consideration should be given to forming an LLC in a state that does offer such protection.

Full-shield limited liability protection is ideal. Some states offer only a limited shield (i.e., a stripped-down version) of limited liability for the owners of limited liability partnerships (LLPs). In particular, the limited shield means that the owners of an LLP will have limited liability only with respect to the actions of their co-owners; the owners will still have unlimited, personal liability in all other cases.

If the home state only offers this limited-shield version, and an LLP is the type of entity that will be formed, consideration should be given to forming the LLP in a state that offers this full-shield protection. Delaware and Nevada are two states that offer this protection.

Evaluate management flexibility permitted

Some states create mandatory voting rights for all members of a limited liability company (LLC) on certain issues, even when the LLC is managed not by all the members, but by a small group of members who are termed the "managers." This can cause confusion and can make certain votes illegal. It also can interfere with an estate planning strategy--the use of the family limited liability company, where children are given nonvoting interests.

LLC statutes in some states make it clear that the operating agreement can provide that members have no voting rights at all, or limit voting rights to only certain matters. Delaware is one of those states. When the law in the home state accords all members certain mandatory voting rights, consideration should be given to forming the LLC in Delaware, or in some other state that allows the owner to completely eliminate voting rights for selected members. In addition, the Delaware LLC statute may offer greater protection in the event one of the LLC members declares bankruptcy.

Consider states that allow series LLCs

Delaware law permits series LLCs. Moreover, the Delaware LLC statute provides incredible flexibility and simplicity in forming and operating the LLC. It has no counterpart in statutes governing corporations (nor even in LLC statutes found in other states.) For instance, it allows the forming of an entity within an entity, thus eliminating the need to form separate LLCs (or corporations) for each separate operating activity carried out by the business.

Each entity within the single LLC can have its own accounting system, own its own assets and be liable only for its own debts as if each entity were a separate LLC. Thus, in many cases, a single LLC can be used to manage the holding entity, as well as the multiple operating entities using multiple holding and operating companies.

This may lead to fee savings, as the single LLC would require a formation fee in Delaware and a single registration fee elsewhere where it does business. It also eliminates the question as to whether an out-of-state holding entity also must register to do business in other particular states.

Know state tax ramifications for entity selection

Ordinarily, a limited liability company (LLC) and a subchapter S corporation are not subject to state income taxes in a state in which they conduct no business and in which the owners do not reside. This may make it desirable to form the entity out-of-state. The owners will be subject to state income taxes in the state in which they reside or the state in which the entity conducts its business activities (usually, but not always, the same state). Delaware and Nevada, two popular states for the formation of LLCs and corporations, both follow these rules.

Moreover, most states will follow the presumed tax status of the LLC (as a conduit) and the federal subchapter S tax election of a corporation (to be taxed as a conduit). However, a few states may not recognize the subchapter S election. These states may impose state income taxes on the corporation even when it does no business in the state. It also is remotely possible that a state would still treat an LLC as a corporation for state income tax purposes and impose taxes on it regardless of whether it conducts operations there.

Although these situations are unlikely to be encountered, it's a good practice to check with state taxing authorities before choosing a state in which to form the business--or form the business in a state such as Delaware or Nevada, which provides clear rules favorable to the small business owner.

Look for a business-friendly state

While every state allows you to form a corporation or an LLC, not all of them offer some of the newer, more effective asset protection and business management entity types, such as a statutory close corporation or a domestic asset protection trust.

Not all states permit statutory close corporations

Some states have a special statutory close corporation statute that is very favorable for owners of small corporations. The statutory close corporation statutes relax many of the formalities normally applicable to a corporation. Basically, these statutes allow the corporation to be operated similarly to a limited liability company (LLC).

Specifically, these corporations may do away with a board of directors, and shareholders can run the corporation, by way of a shareholder agreement, which is similar to an LLC operating agreement. Generally, shareholders do not have to hold meetings.

A failure to follow the formalities normally applicable to a regular C corporation can form the basis for a court's decision to pierce the veil of limited liability and impose unlimited, personal liability on the owners. With the absence of such formalities in the statutory close corporation, the likelihood of this doctrine being applied is lessened significantly.

Thus, if a corporation is to be formed, it should usually be formed as a statutory close corporation. This can only be done in the small group of states that allow this option, such as Delaware and Nevada.

Forming an entity out-of-state will not create additional costs if, for example, the holding entity is formed out-of-state and the operating entity is formed in the owner's home state. The activities of the out-of-state holding entity should not rise to the level of "doing business" in the home state. Thus, the holding entity should not have to register in the home state.

Essentially, only the interest in the holding entity requires extra protection, as the holding entity will house the wealth of the business through strategic funding practices. The holding entity will normally own the operating entity and the most valuable assets used by the operating entity. The assets owned by the operating entity will be protected in other ways, such as with liens that run to the holding entity.

If additional costs are not an issue, the ideal situation may be to form both the holding entity and the operating entity in an asset protection-friendly state, such as Delaware. This may mean three fees (two formation fees, plus a registration fee). Even if additional costs are involved, however, the benefits will outweigh those costs in most cases.

Asset protection trust options exist in a few states

Forming the holding entity in Delaware, Nevada, or Alaska can be part of an overall asset protection plan because these states have statutes authorizing the creation of domestic asset protection trusts. However, this is a significant departure from domestic law in the United States. Accordingly, a trust created under either of these statutes could be challenged on jurisdictional grounds.

One way to bolster the validity of these trusts is to create additional "contacts" in Delaware or Alaska, where the trust is formed. Having a holding entity formed the state that funds the asset protection trust located there would create additional contacts in that state.

Certain states facilitate the use of holding companies

If you are forming a holding entity and an operating entity, consider forming the holding entity out-of-state, in particular, in Delaware, and the operating entity in your home state (or where the business's activities will be conducted).

Forming the holding entity out-of-state will produce no additional costs. There will still be only two state fees: one to form the holding entity and the other to form the operating entity. The small business owner should take the lead from larger businesses and consider Delaware as the site for the holding entity. This also may help sustain the validity of an asset protection trust formed there.

In addition, if fees are not a significant concern, consider forming both the holding entity and operating entity in Delaware, so that Delaware law will govern each entity. Here, the operating entity will have to register to do business in the owner's home state (or where the business's activities will be conducted), thus creating a third fee. However, this fee may prove to be an inexpensive form of insurance. This option is more attractive when the home state's limited liability company (LLC) statute does not effectively protect an owner's interest from his personal creditors.

Note, too, that, the Delaware LLC statute allows for the creation of multiple entities within the form of a single entity. This can make the formation of an LLC in Delaware less expensive.

Delaware's security registration exemption could prove important

Unlike other states, Delaware expressly exempts from securities registration all limited liability company (LLC) interests that are not actually traded in a securities market, such as in a family LLC. This kind of flexibility is particularly advantageous when, in the manager-managed LLC, non-manager interests are to be issued.

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