There may be reasons (or not!) to start your business in a state where it isn’t located.

Business owners often follow the lead of large companies when they form a business entity. Often, these larger companies have the resources to hire the best attorneys to decide where to incorporate, and these attorneys typically advise them to form in Delaware.

According to the Delaware Division of Corporations, more than 66% of Fortune 500 companies and more than 80% of public companies are incorporated in Delaware. Because most large, well-known companies are Delaware entities, it makes sense that many people think it’s a good idea to start their businesses in Delaware, despite their business having no connection whatsoever to the state.

Delaware general corporation law is among the most flexible for the creation and protection of corporations, and the Delaware Court of Chancery provides a low-cost venue to settle business disputes. The state of Delaware emphasizes these advantages and openly caters its laws to the formation of entities in the state, because it recognizes that corporate fees are a substantial source of revenue for the state.

Nevada is another state with a reputation for catering its laws to the formation of corporate entities under its jurisdiction. Nevada has no state corporate income tax and does not require any shareholders, directors or officers of a corporation, nor members or managers of an LLC, to be residents of Nevada.

Despite the advantages of incorporating in Delaware or Nevada, business owners should consider the initial and ongoing costs of forming and maintaining a business in those states—in addition to cost and compliance requirements in the state where their business is physically located.

If your business conducts most or all its activity outside of Delaware or Nevada, you’ll likely be required to register as a “foreign entity” in the state where your business is located. For example, a “foreign entity” for the state of California is any entity formed in a state other than California. On the flip side, if you form an entity within California and your business conducts most or all its activity within California, the entity is considered a “domestic entity.” All 50 states classify companies with the same foreign/domestic perspective.

Foreign Entity Registration and Compliance
How do you know whether you need to register as a foreign entity in a state?

All states provide guidelines about which activities do or do not require registration. The two best places to find these guidelines are the state’s Secretary of State website (or the state agency that handles the formation of entities in the state) and the state taxing authority. State tax rules are a good place to look because the main reason states want a company operating within its borders to register is so the state can collect taxes, fees and related revenue.

For example, in California, the California Corporations Code and the California Revenue and Taxation Code require a company formed in a state other than California to register in California as a foreign corporation, foreign LLC, or foreign partnership if the company is seen as “doing business” in California.

Although the California Corporations Code provides a limited list of activities that do not constitute doing business in California, the California Revenue and Taxation Code provides additional clarity. Doing business under the California Revenue and Taxation Code is described as “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit.” The Taxation Code then goes further and provides quantitative rules to determine whether a company is seen as “doing business” in California.

In California, a foreign entity must register with the California Secretary of State if its business activity in California exceeds the lesser of $500,000 or 25% of the business’s total sales. The foreign entity must also register if the real and tangible personal property of the business in California exceeds the lesser of $50,000 or 25% of the business’s total real and tangible personal property. In practical terms, California gains significant revenue from requiring the registration of foreign entities doing business in the state, which fuels its foreign entity process.

Some professions require foreign entity registration regardless of quantitative thresholds, so it is important to review a state’s Secretary of State guidelines and the state taxing authority together to ensure compliance.

The process of registering a foreign company in most states is similar to forming a domestic company. Foreign company registration usually requires filings with the Secretary of State, a registration fee, the payment of an annual franchise tax and ongoing compliance similar to that of a registered domestic entity.

How to Change Where Your Company Is Domiciled
If your company is a Delaware entity and you wish to change it to the state in which the company is physically located, this is called “domestication” or, simply, “changing your company domicile.”

Each state is different, but the basic steps you must follow for domestication are to:

• Make sure your company is in good standing in the state in which it was formed (this typically requires a Certificate of Good Standing from the formation state).
• File a new articles of organization for an LLC, or articles of incorporation for a corporation, in the new state.
• Ensure you properly dissolve the entity in the old state. The new state of formation may require proof that the former entity was dissolved.

Keep in mind that the original and new state may have various other filing requirements to complete the process of domestication. Though it is likely the most expensive choice, the easiest way to ensure you are moving your entity correctly is to contact an attorney in the state to which your entity will be moved.

In General, Avoid Delaware and Nevada
In most cases, registering your company in Delaware or Nevada only adds cost and complexity, with no real advantages for your company. In addition to annual fees, taxes and ongoing compliance, your company must have a registered agent for service of process in Nevada or Delaware.

For large corporations with thousands of shareholders, Delaware is likely the best location for the company to incorporate due to the state’s laws, legal system and experience with large and complex organizations. This is beneficial even if your business is based in another state. However, if your business is smaller, and you do not anticipate going public or having thousands of shareholders and potential lawsuits, it is likely best to form your entity in the state where your business is located to avoid unnecessary costs and additional compliance.

Nevertheless, because Delaware entities (especially corporations) are often seen as offering a company an air of credibility or legitimacy, it may be wise, for presentation purposes, to register an entity in Delaware. Companies seeking investor capital may be more successful registering in Delaware if their potential investors prefer owning shares in a Delaware corporation due to the state’s favorable reputation.

In conclusion, most business owners are best served to form their entity in the state where the company is based to prevent additional fees and compliance requirements. However, there are circumstances where registration in a specific state may have its advantages (e.g., providing peace of mind to investors) despite the added cost and compliance.