Organizers of a business generally have a choice on where to incorporate the business. In the United States, business entities are generally organized pursuant to state law, rather than federal law. Moreover, a business need not establish or maintain a physical presence in a state in order to form an entity under the state’s various business formation statutes. Courts will generally apply the law of the state of formation to the “internal affairs” of the business entity.
There are several popular jurisdictions available to business owners for incorporating their entity. The choice of the jurisdiction ultimately depends on the owners’ residence status and intentions vis-à-vis the physical location of his or her business, business growth model (i.e. whether he or she intends to seek for institutional investments and whether he intends to grow his or her business into large publically traded company.
Forming a business entity in California is an obvious choice for a business owner who (i) resides here and intends to conduct his or her business locally, from within California, (ii) does not intend to seek financing from venture capital funds or any other institutional investors as part of his or her business growth strategy, and (iii) does not intend to grow his or her business into a large, publically traded company. All three of these must be answered in the affirmative in order for California to be the unambiguous choice as the jurisdiction of entity formation. If any one of these is answered in the negative, other jurisdictions discussed below must be considered.
The disadvantages of forming a business entity in California are high corporate income taxes, less protection from having the limited liability veil pierced by a court (as compared to Delaware or Nevada), courts that are not as focused on, and experienced with, various business entities forms as they are in some other jurisdictions (as compared to Delaware), and more stringent rules regarding application of the business judgment rule to actions of the management of the business.
A business owner should seriously consider forming his or her entity in Delaware if he or she (i) intends to seek financing from venture capital venture capital funds or any other institutional investors, and/or (ii) intends to grow his or her business into a large, publically traded company. Such business owner would most likely be interested in forming a Delaware C-Corporation, as that is the form most preferred by institutional investors and most often used by large, publically traded corporations. In addition, a business owner who does not reside in California nor intends to physically conduct the business in California (i.e. a foreign business owner who does not reside in the United States, but wants to base his or her business entity therein) should seriously consider Delaware as the place for forming his or her business entity.
Pursuant to the “internal affairs doctrine,” corporations which act in more than one state are subject only to the laws of their state of incorporation with regard to the regulation of the internal affairs of the corporation. As a result, Delaware corporations are subject almost exclusively to Delaware law, even when they do business in other states. Among other reasons, this contributes to Delaware’s attractiveness as a state of incorporation.
Because of the extensive experience of the Delaware courts, Delaware has a more well-developed body of case law than other states, which serves to give businesses, and especially corporations, and their counsel greater guidance on matters of business and corporate governance and transaction liability issues. Disputes over the internal affairs of Delaware corporations are usually filed in the Delaware Court of Chancery, which is a separate court of equity, as opposed to a court of law. Because it is a court of equity, there are no juries, and its cases are heard by the judges, called chancellors. Since 1989, the court has consisted of one Chancellor and four Vice Chancellors. The court is a trial court, with one chancellor hearing each case Litigants may appeal final decisions of the Court of Chancery to the Delaware Supreme Court.
While most states require a for-profit corporation to have at least one director and two officers, Delaware laws do not have this restriction. All offices may be held by a single person who also can be the sole shareholder. The person, who does not need to be U.S. citizen or resident, may also operate anonymously with only the Resident Agent with whom the company is registered with Delaware named. This proves advantageous in civil suits as the owner or owners cannot be disclosed under Delaware law and thus are safe from being sued alongside the company. However, this does not apply if the civil suit is in regards to having committed a criminal act which the business has been found guilty of in court.
Delaware charges no income tax on corporations not operating within the state, so taking advantage of Delaware’s other benefits does not result in an income tax cost. A state may levy, however, a franchise tax on the corporations incorporated in it. Franchise taxes in Delaware are actually far higher than in most other states, but are not as high as in California.
A business owner who does not reside in California nor intends to physically conduct the business in California (i.e. a foreign business owner who does not reside in the United States, but wants to base his or her business entity therein) should seriously consider Nevada as the place for forming his or her business entity. A Nevada corporation would be unsuitable though to someone who is planning to seek financing from institutional investors.
With respect to corporations specifically, Nevada’s laws offer flexibility to a board of directors in managing the affairs of a corporation, and permit management to put in place strong protection from hostile takeovers. It also provides extremely strong protection against piercing the corporate veil, where a corporation’s owners can be held responsible for the actions of a corporation. In only one case within the last twenty-five years has the piercing of a corporate veil been permitted under Nevada law, and in this single case the reason was because of obvious fraud on the part of the corporation’s owners.
Because the provisions on “piercing the corporate veil” are corporate governance matters, if a corporation chartered in California, for example, (which has much more creditor friendly provisions permitting this) is sued anywhere, California law applies, but if a corporation chartered in Nevada, which operates only in California, is sued in a California court, the California court would use Nevada law in determining what are the requirements permitting this. On the issue of “piercing the corporate veil,” Nevada law applies (which is much more supportive of the corporation’s interest), even if the corporation only operates in California and has never had any other contact with Nevada and is simply chartered there as a “flag of convenience.”
Nevada (unlike most other states, including California) permits the corporation’s articles of incorporation to vest authority to adopt, amend or repeal bylaws exclusively in the directors, so that shareholders would not be able to change the corporation’s bylaws.
Nevada’s tax structure is also a large benefit to incorporation in Nevada. Nevada has no franchise tax and no corporate income tax or personal income tax. There is, though, an annual $200 Business License Fee which is paid to the Secretary of State at the time of formation or renewal of the corporation. Nevada additionally applies a 1.17% tax on gross wages to most businesses with a payroll over $62,500.