Where to Form Your LLC: A Strategic Guide for State Selection

08 Sep 2023 Where to Form Your LLC: A Strategic Guide for State Selection

The choice to start your own limited liability company (LLC) can be both exciting and daunting. You likely have a clear vision for your business, but you might be uncertain about the next steps, particularly when it comes to where you should incorporate.

Choosing a state for incorporation: factors to consider

In the process of incorporating your LLC, your choice of state can significantly impact your business’s financial and legal aspects. Business owners often choose their home state for incorporation, but this may not always be the best choice.

Here are some key factors you should consider when determining the best location for your LLC:

• Annual fees and franchise taxes: Each state imposes a different structure for annual fees and franchise taxes, which can impact your bottom line.

• Sales tax compliance: If your LLC will be selling goods and services in various states, you will need to consider how respective states’ sales tax can affect your operations.

• Personal and corporate income taxes: Income taxes vary greatly among states, with some states imposing no income tax at all. Consider the tax implications for both your business and personal income, as an LLC’s profits typically flow through to the owners.

• Owner privacy: Some states provide better privacy protection for LLC owners than others. For example, in certain states, the owners’ names and addresses are not publicly accessible.

• Business operations and nexus: If your LLC has “nexus” in a certain state, you might be subject to that state’s taxes and regulations.

It’s worth noting that LLCs are considered pass-through entities by default for federal income tax purposes (however, it is possible for LLCs to choose to be taxed as corporations). This means that the profits and losses of the LLC pass through to the owners, who report them on their individual tax returns. Therefore, LLCs generally do not pay federal corporate income tax at the entity level.

However, the term “corporate income tax” at the state level can sometimes refer to taxes levied on businesses in general, including LLCs and other pass-through entities. Some states levy various taxes and fees on LLCs at the entity level, although they may be referred to by other names such as “franchise taxes” or “annual report fee.” These are essentially fees for the privilege of doing business in that state.

Understanding nexus and its implications

What is nexus, and how does it relate to where I form my LLC?

“Nexus” is a Latin word meaning “connection” or “link,” and it refers to a business’s significant presence or economic connection within a state. If a business has nexus in a particular state, it is generally obligated to pay taxes and comply with certain regulations in that state.

It is worth noting that a full explanation of nexus is beyond the scope and intent of this article. Nexus is a complex area of tax law, and different states have different rules about what constitutes a nexus, particularly for online businesses. You should always consult with legal and financial experts to determine if your business has nexus in a particular state based on your unique circumstances. Nevertheless, there are some general factors that can establish nexus, including:

• Physical presence: If your business has a physical location or property, such as a store in a state, it typically establishes nexus there.

• Employees: If your business employs people in a state (not including independent contractors), that usually creates nexus in that state.

• Sales: Some states establish a nexus based on a business’s sales within the state. For example, if your business exceeds a certain sales threshold in a state, it could create a sales tax nexus.

What are the potential tax implications related to nexus?

Establishing a nexus within a state can have significant tax implications for your LLC. Once a business nexus is established, your business may be subject to various state and local taxes, including sales tax, income tax, franchise tax, payroll taxes, unemployment insurance, property taxes, and use taxes.

What are the advantages of incorporating in my home state?

Incorporating your LLC in your home state has several advantages, especially if most of your business activities will be conducted there. Here are some benefits to consider:

• Convenience and familiarity: You may already be familiar with the local regulations and tax laws you’ll need to follow. Likewise, any required filings, documentation, or visits to state offices will be more convenient.

• Lower costs: You’ll typically avoid the extra expenses that come with the need to register in more than one state. These costs can include additional filing fees, annual report fees, and the cost of hiring a registered agent in another state.

• In-state tax advantages: If your business operates primarily in your home state, incorporating elsewhere could lead to additional tax complications. For example, you might be subject to taxes in both your state of operation and the state of incorporation.

• Local funding opportunities: Some states offer grants, loans, and other resources to businesses incorporated and operating within their borders. You might have easier access to these resources if your LLC is incorporated in your home state.

• Professional licensure: Certain professionals, such as doctors, lawyers, and real estate brokers, often need to incorporate where they are licensed, which is typically their home state.

What are the advantages of incorporating my LLC in another state?

While incorporating your LLC in your home state might seem like the obvious choice, there can be substantial benefits to incorporating in another state, depending on your business type and plans for growth. Here are some potential advantages:

• Cost savings: Different states have varying tax rates and fees, which can result in potential savings for your business. However, it’s important to note that your LLC may still be required to pay taxes in a higher-tax state if it has nexus there. It’s important to remember that state income taxes on the profits drawn from your LLC will likely be owed in the state where you personally reside, regardless of where your LLC is incorporated.

• Business-friendly laws: Some states are known for having laws that are especially favorable to businesses. Delaware, for example, is famous for its Court of Chancery, which specializes in corporate issues and uses judges, not juries, leading to more predictable outcomes.

• Asset protection: Certain states have laws making it harder for creditors to access your assets. For instance, states like Wyoming and Nevada have strong asset protection laws that can help safeguard your personal and business assets from lawsuits.

• Privacy: The level of required disclosure about your company and owners varies by state. Some states allow for a higher level of owner privacy, as they do not require the owner’s name to be publicly listed.

• Attracting investment: If you plan to seek outside funding, incorporating in a state known for its stable, business-friendly laws can be attractive to investors. Many investors, particularly for larger investment rounds, prefer or require companies to be incorporated in Delaware.

Popular states for LLCs

There are a few states that have garnered a reputation for being particularly favorable to businesses due to their legal structures, tax policies, and other factors. Three of the most popular states for LLC formation are Delaware, Nevada, and Wyoming.

Delaware

Delaware is often touted as the most business-friendly state in the U.S. Here’s why:

• Well-established corporate laws: Delaware has a comprehensive and well-established body of corporate law that provides predictability for businesses.

• Court of Chancery: This is a specialized court that handles only corporate disputes. It’s well-regarded for its expertise, and it uses judges instead of juries, which can lead to more consistent outcomes.

• Privacy: Delaware doesn’t require member or manager names to be listed in the formation documents.

• Investor preference: Many investors prefer (or even require) businesses to be incorporated in Delaware, particularly for larger investment rounds.

Incorporating in Delaware also presents certain challenges and potential drawbacks. Here are a few considerations to keep in mind:

• Tax and reporting: Delaware requires all LLCs to pay an annual franchise tax of $300 and to file an annual report.

• Legal complexity: The complexity of Delaware’s legal system can be a drawback for smaller businesses that may need to hire a Delaware attorney with experience litigating in Chancery Court.

• Business type: Major corporations often leverage Delaware’s tax laws through a complex process of establishing shell companies designed to offset taxes. However, the complications and costs associated with these strategies are likely beyond the reach of the average small business owner.

Nevada

Nevada has emerged as a popular choice for businesses due to its pro-business and privacy laws:

• No state-level tax: Nevada has no corporate income tax, no personal income tax, and no franchise tax.

• Privacy: Like Delaware, Nevada offers a high level of privacy. It doesn’t require the disclosure of member or manager names in the formation documents.

• Asset protection: Nevada has strong laws protecting directors and officers from personal liability for lawful acts on behalf of the business. These laws go beyond the basic limited liability protection provided by the LLC structure in all states. For example, Nevada LLCs have “charging order protection.” This means that creditors or the members or owners of a Nevada LLC cannot lay claim to the member’s interest in the LLC to settle a debt. Additionally, they are prohibited from forcing the sale of a member’s interest or assuming their membership in the LLC.

• Flexibility: Nevada does not require operating agreements or annual meetings for LLCs, providing a degree of operational flexibility.

• No information sharing: Nevada has no information-sharing agreement with the IRS. An information-sharing agreement is an automatic way for the IRS and the state to cross-check data and ensure compliance with tax laws. However, this does not mean that an LLC can avoid federal taxes or that the IRS cannot access information about a Nevada business pursuant to a specific request.

While Nevada has a reputation as a favorable location for incorporating a business, there are several considerations and drawbacks to be aware of:

• Annual costs: Nevada requires LLCs to make an annual filing along with a state business license. These fees typically start at $350. However, fees can change annually, so check Nevada’s Secretary of State website for current information.

• Taxes for certain businesses: Nevada businesses with gross earnings over $4 million may be subject to Nevada’s Commerce Tax.

• Lack of case law: While Nevada’s business statutes are generally viewed as favorable to businesses, there is less case law in Nevada compared to states like Delaware. This means there might be less legal predictability if your LLC becomes involved in a legal dispute.

• Perception and reputation: Although many legitimate businesses incorporate in Nevada, the state’s lax disclosure requirements have been associated with misuse by some. Depending on your industry and the specifics of your business, potential investors, partners, or clients may view a Nevada LLC with some skepticism.

Wyoming

Wyoming, like Nevada, offers attractive features for business owners and has been growing in popularity for LLC formation:

• Favorable tax structure: Wyoming has no corporate income taxes, franchise taxes, or personal income taxes.

• Sales tax: Wyoming boasts one of the lowest sales tax rates in the country at 5.36%.

• Privacy: Wyoming allows a high level of owner privacy, not requiring the listing of member or manager names in the public records.

• Asset protection: Wyoming has strong asset protection laws, including allowing the creation of single-member LLCs, which have the same level of liability protection as multi-member LLCs. Also, Wyoming LLCs continue indefinitely regardless of changes to membership (traditionally, the articles of incorporation must specify when the LLC will terminate). Like Nevada, Wyoming also offers charging order protection.

• Low fees: The cost to form and maintain an LLC in Wyoming is relatively low compared to many other states. Its initial filing fee of $100 is one the lowest in the country, making it financially accessible for many businesses.

Here are some potential considerations and drawbacks to incorporating in Wyoming:

• Annual report and fee: Wyoming LLCs must file an annual report and pay a fee. The fee is based on the reported assets located in Wyoming and starts at a minimum of $60.

• Lack of established case law: There is less case law compared to a state like Delaware and even Nevada, meaning you’ll have less legal predictability.

• Perception and reputation: Wyoming may not have the same prestige or recognition as states like Delaware or Nevada.

Making the decision

Choosing where to form your LLC is a significant decision and one that should be made based on your specific business needs and circumstances. Here are some questions to discuss with your tax or legal advisor:

What are the tax implications of forming an LLC in my home state versus another state? 

Remember, nexus is a complex and nuanced subject that varies greatly among states. You’ll need to consider where you will have nexus for various taxes, keeping in mind that you might have nexus in a state for one type of tax (e.g., income tax) but not another (e.g., payroll or sales tax).

Will I need to register as a foreign entity in other states, and what are the associated costs and requirements? 

If you are primarily doing business in one state, it often makes the most sense to form your LLC in that state to avoid the additional fees and paperwork associated with foreign qualification.

Are there specific legal advantages or disadvantages to forming an LLC in a particular state, given my business model? 

The legal system and business laws of a state can have a significant impact on your LLC. Some states are considered more favorable to businesses than others. This can also differ depending on your industry and niche.

How do privacy laws vary between states, and how might these impact my business? 

Consider how much privacy matters to you with respect to your business dealings. If privacy is a significant concern, you may want to consider a state known for strong privacy protections for LLCs, like Nevada or Wyoming.

How do the ongoing costs of maintaining an LLC compare between states? 

Research the costs associated with forming and maintaining the LLC, including the initial filing fees, annual report fees, and the potential costs needed to register as a foreign entity. Also, keep in mind that these fees vary greatly among states (including the number of different fees to which your LLC will be subject) and can change annually.

This article is intended to provide a brief overview of choosing a state for your LLC. It is not a substitute for speaking with one of our expert advisors, nor is it intended as legal advice. For more information and individualized advice, please contact our office.

Contact The Haynie & Company CPA Firm For Tax Advisor Services