Are you thinking of starting a new business? Or perhaps you’ve been operating for a while but now realize you should create a legal entity to protect yourself?
If you’ve decided to form a corporation or LLC, you’re on the right track. But did you know each state has its own laws governing legal entities? Where you choose to incorporate can drastically affect your fees, legal safeguards, and privacy.
Are you ready to learn how to protect yourself (and your business)? Read until the end for some helpful images showing different asset protection strategies.
Let’s dive in!
Can I Organize My Corporation or LLC in Another State?
Let’s start with the basics. You can organize your legal entity in whichever state you want.
If you run a California-based restaurant, record label, or real estate rental business, you’re free to choose another state as your company’s domicile. “Domicile” is a fancy word for home state.
Many businesses choose to incorporate in Delaware, Nevada, or Wyoming, even if they don’t actually do business in those states — we’ll explain why soon.
Foreign Qualification — Permission to Operate Your Business in Another State
Even if you organize your business in another state, you still need to get permission to operate in jurisdictions where you “do business.”
Are You Doing Business in a State?
You’re probably doing business in a state if you:
- Have an office, employees, and warehouses in the state.
- Market your products or services to individuals in the state.
- Own or lease real property in the state.
California Corp Code § 191 contains a list of several activities that don’t automatically mean your company is doing business within the state.
Examples include:
- Selling to residents through independent contractors.
- Maintaining a bank account.
- Holding board meetings.
Each jurisdiction has its own test, so make sure to review the laws of any state where you operate.
Applying for Foreign Qualification
Assuming your company does business in a state, you’ll need to apply for foreign qualification. When it comes to corporate law, “foreign” means your business is organized in another state — not another country. So, if a Delaware corporation does business in California, it’s “foreign” from California’s perspective.
Each state has its own forms and procedures for foreign qualification. For a foreign LLC in California, you’ll need to submit an Application to Register a Foreign Limited Liability Company (Form LLC-5). You’ll need a different form to register a foreign corporation. Check with the local Secretary of State to confirm the proper fees and procedures.
Out-of-State Registered Agents
When you organize a business, the state typically requires you to appoint a registered agent. Your agent is responsible for receiving legal documents and correspondence from the local Secretary of State.
While you may serve as your own registered agent, you generally need a physical in-state address. If you live and run your business in California, but you choose to incorporate in Delaware, you’ll need a local Delaware registered agent to be your boots on the ground.
If you qualify your business to operate in 11 different states, you’ll need a local registered agent with a physical address in each state. Some agents have physical offices in multiple states, which can help you avoid administrative headaches.
Fees for Foreign Qualification
Unfortunately, you’ll have to pay a fee every time you qualify your company to do business in another state. Plus, you’ll be responsible for yearly dues to keep your business in good standing.
The costs can add up. For example, let’s say you want to form a Delaware LLC and qualify to do business in California.
Set-up costs
- Delaware Certificate of Formation: $90
- California Foreign Qualification: $70
Annual Expenses
- Delaware annual tax: $300
- California annual tax: $800
As you can see, you would have to pay $160 to set up your LLC, plus $1,100 in yearly taxes. And that’s without considering fees for registered agents, lawyers, or expedited filing! Granted, California has some of the highest taxes in the country — other states like Wyoming charge as little as $50 per year. But still…expenses are expenses.
Fun Fact: Texas charges more for foreign qualification than setting up an in-state LLC.
So, given the extra fees, why would you choose to organize your business under the laws of another state?
Reasons to Organize Your Business in Another State
Despite the fees, many business owners decide to set up their business’s legal entity in another state and qualify to do business wherever they operate. Established jurisprudence, increased privacy, and strong charging order protection lead entrepreneurs to organize their corporations and LLCs in foreign jurisdictions.
Established Jurisprudence — Increased Certainty
Uncertainty is the enemy of business. Some states, like California, are known for wild card court rulings that may adversely affect your investment in your company. Other states, like Delaware, tend to be more business-friendly, with pro-management policies that enable entrepreneurs to maintain control.
Delaware even has a special, jury-free court called the Court of Chancery, which has jurisdiction over business-related matters. Expert judges employ the Delaware business judgment rule and defer to the good-faith decisions of a Delaware corporation’s directors. The business judgment rule helps protect business owners and other insiders from certain claims involving breach of fiduciary duties.
The extra fees to maintain a Delaware corporation or LLC may be a small price to pay for the reliable, business-friendly courts.
Enhanced Privacy — Increased Anonymity
Some states, like California, require businesses to submit yearly statements of information identifying key insiders. Some business owners would rather keep their names out of the public record.
On the other hand, states like Nevada and Wyoming don’t require owners to identify themselves. While a Nevada corporation must disclose its directors and officers in annual reports, the shareholders stay out of the limelight — as do an LLC’s members.
In Wyoming, LLCs never need to disclose their managers or members. Many business owners value privacy — it never hurts to limit public information regarding your assets.
Charging Orders — Increased Asset Protection
Speaking of asset protection, it’s time to discuss charging orders. This will get a little complicated, but it’ll be worth it. I promise.
Let’s start with an example.
Pretend you’re the target of some frivolous litigation. Absolute nonsense. Baseless accusations. The plaintiff knows it’s ridiculous, but he or she tries anyway.
If the plaintiff wins, a court might award them your stock holdings — this includes shares of your business. Not only would you lose the monetary value of your shares, but your voting control might be in jeopardy. Not ideal.
Luckily if you set up your business as an LLC, you may be able to avoid this problem. Many won’t make you transfer your LLC interests to a judgment creditor (a plaintiff who wins a lawsuit against you).
Instead, the court might issue a “charging order.” Under a charging order, you get to keep your LLC interests (including management rights), but the judgment creditor gets the right to take any profits distributions in your place.
But remember — you keep your management rights. So, you could technically decide to forego profit distributions (taking a salary instead), preventing a judgment creditor from getting access to your funds.
Some attorneys argue that the judgment creditor may still have to pay taxes on their share of the LLC’s profits, even without receiving any distributions — this is called “phantom income.” However, because the judgment creditor merely has a lien on profits distributions, it’s far from certain that judgment creditors would actually have to pay taxes on phantom income. In any case, the mere threat of a creditor paying taxes on money not received may make you a less likely target for frivolous litigation.
States like Nevada and Wyoming have very strong charging order protections — they say that a charging order is the only remedy for a judgment creditor with respect to an LLC interest. Recently, Nevada has even extended charging order protection to closely-held corporations.
While some states like California deny charging order protection to single-member LLCs, other states, including Nevada and Wyoming, protect them. If you have your heart set on a California LLC, consider adding another member to guard against losing charging order protection.
Entity Stacks — The Ultimate Strategy for Asset Protection
Are you looking to protect yourself (and your business) as much as possible? If so, you might want to consider creating a series of entities to segregate your operating company from a second entity that holds your business’s essential assets.
For example, if you run a Los Angeles-based technology company, you could create one corporation for your customer-facing business and a second corporation to hold high-value intellectual property. Assuming you follow standard corporate formalities, you’ll be able to segregate your liability. If a customer sues your operating business and wins the judgment, your IP will be safe and sound.
Here’s how that might look:
Better yet, consider creating a Nevada, Wyoming, or Delaware LLC to serve as a holding company. That way, if judgment creditors try to reach your assets, you’ll be shielded by pro-management case law (Delaware) or super-strong charging order protections (Nevada and Wyoming).
Here’s an example of how this might look:
Another option could be to create two foreign entities and then qualify those corporations to do business in California. For example, your setup could look like this:
This approach gives you fewer entities to keep track of. However, you’ll have to pay both California and Delaware fees on both S-Corps.
If you have several entities, creating one overarching holding company may save you money in the long run, because each entity will only need to be qualified in the jurisdictions in which it operates. (However, it should be noted that California’s tax authority — the Franchise Tax Board — is super aggressive, so you may want to check with your legal/tax representative to determine whether your holding company needs to qualify to do business in California.)
Need Help Setting Up Your New Business?
I know this is a lot to take in. If you’re thinking about setting up a new business (or revamping your current structure), I’m here to help. I work for TroyGould, a business law firm with over 50 years of experience representing clients both large and small.
Shoot me a message on LinkedIn or email me at MichaelBHuseby@gmail.com to connect!
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