Why forming in the First State shouldn’t always be your first choice.
The second smallest state in the Union sure has an oversized role when it comes to corporate governance. Legal entities actually outnumber Delaware residents in most years, and around two-thirds of the Fortune 500 companies are headquartered in the state. As the owner of a small business, you might be wondering whether you should be following their lead instead rather than forming in your own backyard.
There are several major tax and financial advantages to incorporating your company in Delaware. The eponymous “Delaware loophole” doesn’t tax revenue earned outside the state, and revenues derived from exploiting intangible assets (like leases and royalties) are treated as if they occurred in Delaware (where the company is incorporated) rather than the state in which those revenues were earned.
Companies in Delaware also don’t have to publicly disclose their ownership, which allows shell companies to thrive in secret. California entities must file an annual or biennial Statement of Information that lists the corporation’s directors and officers (or the managing members, in the case of an LLC).
Finally, the court system and the Division of Corporations are set up to make filing and dispute resolution seamless. A Court of Chancery, a specialized court that hears corporate cases, has judges with corporate law backgrounds, and matters can be resolved quickly without relying on juries composed of laypersons.
Companies that are actively contemplating soliciting investment, especially from sophisticated investors, should expect those investors to demand the entity re-domesticate in Delaware for the reasons outlined above. But for most small businesses, including single-member LLCs and closely held corporations, the costs of maintaining a headquarters in Delaware might outstrip the benefits the entity receives.
First, you’ll still need to register your business as a foreign entity in California and any other state you’re operating in, with duplicated franchise (corporate) taxes. So, if your goal was to escape California’s high-tax system while still taking advantage of its large market, you’ll be out of luck.
Second, you’ll have to comply with certain regular filings in both states (for Delaware, your annual reports), creating extra hassle and legal costs.
Third, you’ll have to hire a third party to serve as your agent for service of process in Delaware—the person responsible for receiving lawsuits on your behalf—since you won’t be in the state yourself.
We generally recommend entrepreneurs have a compelling reason to form in Delaware, which in most cases means imminently raising large amounts of capital from investors. For smaller companies, the duplicated efforts and taxation issues might override any benefits they receive from domesticating outside California.