Nevada or Delaware, Delaware or Nevada…that’s typically how the incorporation question is framed. I can’t tell you how many times the following scenario has played itself out. An entrepreneur is ready to incorporate and says to me, “Well, I’m deciding between Nevada or Delaware.”
Each time I hear this, I start off asking two simple questions:
- Is your business physically located in Nevada or Delaware? Well, no…
- Are you planning on opening a bank account? Yes…
And more often than not, the direction of our conversation soon changes course.
But, let’s back up a bit. Nevada and Delaware are popular states for good reason. Many larger corporations choose Delaware because it offers some of the most developed, flexible, and pro-business statutes in the country. And Nevada is increasingly becoming a popular choice for businesses due to its low filing fees, as well as the lack of state corporate income, franchise, and personal income taxes.
However, most small businesses never see the benefits from incorporating in these states, and end up with a lot more headaches and costs than they ever anticipated. As a general rule of thumb, I like to say that if a small corporation or LLC has less than 5 shareholders or members, it is best to incorporate in the state where the business has a physical presence.
Here’s one example (and it explains why I mentioned the bank account up front). The other day, a small business owner from Maryland called me wanting to incorporate in Delaware. I started off with my typical questions…do you have an office in Delaware? No. Okay, will you want to open a bank account in Maryland or Delaware? Well, Maryland. That’s where I live.
As it turns out, Maryland has strong rules pertaining to bank accounts. And as an out of state business, this caller would have needed to ask permission in order to open a bank account in Maryland. Naturally, her next line of thinking was, “Well, maybe I could open my bank account in Delaware then.” But this isn’t so easy either. Without any kind of physical address in the state, opening that account will be just as hard.
And that’s just one particular (albeit very common) logistical challenge. There are countless other potential hurdles, and added fees.
For example, when a business incorporates ‘Out of State’ (aka in Delaware or Nevada), they may be responsible for additional filings and fees in both the state of incorporation (i.e. Delaware) as well as the state where they live and run their business. These can include the following items.
For the state where a business incorporates:
- Appointing a Registered Agent in THAT state
- Paying filing fees in THAT state
- Filing annual reports in THAT state
And then, for the state of residence (or where the business is physically located):
- Appointing a Registered Agent in THIS state
- Paying filing fees in THIS state
- Filing annual reports in THIS state
- Qualifying as a Foreign Corporation in THIS state
- Paying taxes in THIS state
That last point can’t be overstated, as it can be a common misconception for the small business owner. Let’s face it, when a small business is just starting out (or really, during any point in its life), the tax burden seems overwhelming. It’s only natural for small businesses to be concerned about taxes —and those state tax laws from Nevada are incredibly appealing.
However, just because you incorporate your business in Nevada does not mean those are the only tax laws that apply to your business. In other words, while Nevada may not charge state income taxes for your corporation, the state in which your business is physically located will come after you for those taxes sooner or later. And to add insult to injury, your tax liability may actually increase because you’re viewed as a foreign entity operating in the state.
Pretty soon, any benefits from incorporating in Delaware or Nevada are quickly washed away with the added fees and added paperwork of operating out of state. There’s certainly truth behind the hype of these business-friendly states. However, those benefits are really limited to larger businesses (remember the rule: over five shareholders).
As a small business owner, you’re going to have more than enough fun with paperwork and fees as it is; there’s no reason to add more to your workload by trying to operate out of state. And while it’s common for the small business person to worry that he or she isn’t taking full advantage of all potential tax breaks, in this case, the simplest route of incorporating in your own state turns out to be best.