When business entrepreneurs want to start a new business, one of the first questions they must grapple with is State of Incorporation. Generally, the decision is between the state where the entrepreneur lives and works or Delaware. Determining what state in which to form a business requires consideration of several factors, that include:
Physical Location of the Business and Employees
All businesses, regardless of industry, business model or nature, must have a physical presence within at least one state. Logically, that physical presence is in the state where the business activity occurs. Without the other options contemplated below, the decision as to where to incorporate would end with physical location.
If the business is an e-commerce business or a service business where the service provider can provide the services from any physical location, the physical location of the business would be the state of residence of the founder or primary service provider.
Income, Corporate and Franchise Tax Issues
When selecting an entity form, federal taxation considerations dominate the decision (LLC, S-Corp or C-Corp). When selecting a state of incorporation may also be dictated by state “taxation” concerns. When deciding in which state to incorporate a business, state personal income and corporate tax as well as the franchise tax rates and systems need to be considered. For instance, some states do not tax personal income, which may be advantageous to limited liability company members or S corporation shareholders if they can meet the residency requirements of that state. Some states have low or no franchise tax (annual fee paid to the state of incorporation for being an entity formed in that state) while some states have high franchise taxes (Delaware franchise taxes are generally higher). States also differ on corporate tax rates as well. All of these items need to be considered when thinking about state of incorporation.
Financing Expectations
The financing needs and capital raising plans for a new enterprise impact both the form of entity selected as well as the state of incorporation. This is the critical issue that drives incorporation decisions for me.
Business enterprises funded by sophisticated outside investors, such as accredited investors, angel investors, private equity firms or venture capitalist, or “public” companies are typically incorporated under Delaware law. This state dominates for incorporations because (1) most investors are comfortable with Delaware corporate law, (2) Delaware corporate law is management and majority stockholder “friendly” (or minority stockholder “unfriendly”), and (3) Delaware has the most developed body of case law in the United States when it comes to business entities. Generally, if there will be investors who reside in multiple states or regions, Delaware is also a natural choice.
Business enterprises who finance operations through either revenue from operations or bank financing do not necessarily need to consider outside investors’ needs or desires with respect to state of incorporation. Closely-held businesses or corporations that elect to be taxed as S-Corporations should generally select the state where the business activities are located for the state of formation.
