by: Garrett Fisher
February 15, 2013
Forming an entity to do business is enough of a step for someone to get used to when first starting a business. Navigating through a labyrinth of state taxation and legal issues to arrive at the best solution is often disregarded altogether as business owners take the simplest and most naïve option: domiciling in their current home state.
We are not discussing the benefits and/or drawbacks of forming an entity. Those matters stand on their own – and it is assumed that the reader of this article has chosen to form an entity – the question now is tax planning for future events and choosing where to domicile.
Taxation of business activities on a per state basis has been defined into a relatively national standard in the 1990s. The legal concept is called “nexus” and covers whether or not there is a sufficient legal link for a state to impose a tax (aka. “establish nexus”) on a business’ activities in that state. The law triggering nexus is basically the following: having an employee in the state, a physical location in the state or an economic presence – i.e., performing work physically in the state other than on a one-time basis.
For those who don’t venture far from their metro area and stay in their state, then domiciling an entity in their home state is the most that they usually need. The average business owner often has no clue about the above. Where complications and tax planning become necessary are when work is done in more than one state, physical locations will be opened in more than one state, when shareholders live in more than one state or if changes in shareholders or locations are anticipated in the future. The drawbacks for failing to plan are (in order of pain – low to high) superfluous reactive filings, unnecessarily higher state income tax payments or severe penalties for failing to file.
Even if a business chooses to not even bother analyzing where to domicile their entity, they still must be registered in the states they are doing business in. Registration is critically important and cannot be overlooked as states require that entities be admitted to do business in the state. Failing to do so has varying penalties. IL for example, charges $500/mo for late registrations. SC does not charge late fees (on a Secretary of State level – other Departments still apply). NY is acutely burdensome. If your business is venturing into a new state, at the very least check with the Secretary of State in advance of doing business to determine registration requirements.
How State Taxation Works
State taxation follows the following simple order in determining what tax rates apply:
The higher of: what state the work is done in where the shareholders live where the entity was formed.
Lets explain a bit. Where the work is done is of paramount importance to tax rates as one cannot plan for, modify or negotiate that reality. If you are doing work in a particular state, you are going to pay taxes to that state for the work done. Where the shareholders live becomes of secondary importance (yet still important) as the tax rate where the shareholders live may be higher than where the work is done. So, while it is never a good idea for the tax tail to wag the dog – i.e., one should not move states just to save taxes, location of work and residence become important when choosing where to domicile. The last factor is where the entity is formed. After taxes have been paid on location and residence, then if the tax rate of the state where the entity was formed is higher than the other two states, additional tax is due to that state.
Best Practice When it Comes to Domicile
For individuals running a small business, in one state, with no known intention to move, take on partners or open new locations, the best bet is to form the entity in the state that they live in.
If the business plans on having just one location or locations only in one state – no matter where the shareholders live, forming an entity in that state should be fine. If there are desires to open locations in other states, planning would be needed. Further, if any shareholders plan on moving states in the near future, then planning would be needed as it would be beneficial in certain instances to form an out-of-state entity. In others it would be beneficial to domesticate the entity once the move is done.
If there will be multiple locations, or if there will be multiple partners living in multiple states and the business has the proclivity to expand, then an entity should be formed in a zero-tax, corporate friendly domicile. These domiciles are NV, WY and DE. While other states offer zero personal income tax (NH, FL, SD as examples), their regulatory structure makes them not worth electing as an out-of-state domicile.
NV, WY and DE specifically cater to out-of-state individuals forming entities. DE in particular has over 200 years of stable, logical case law in the event of litigation. WY has director and officer friendly legislation, low fees, permits proxy directors and so forth. I recommend DE for established, operating businesses that may anticipate litigation on the director or shareholder level and need a stable case law basis to work from. For small businesses, I recommend WY as recurring annual fees are very low and the process is rather simple. DE is burdensome for a very small operation. NV has advantages – though I have found limited instances where NV would be a better choice than WY or DE. NV has changed their laws to make them a less salubrious choice.
For those opting the route of a tax and business friendly jurisdiction, note a few things:
- Domicile is eliminated as tax concern – so shareholder state and operations state are the two things that govern income tax.
- The entity must be registered with the states where it is doing business.
- The entity still will owe taxes and be subject to the laws of the states it is doing business in.
Out-of-state domicile is not for everyone. Costs and regulatory burdens do increase whereas benefits and protections are subjective to certain situations. Business owners facing a multiple state conundrum owe it to themselves to consult with a qualified professional before running afoul with cantankerous state regulators – at the very least ensuring that entities are at least registered in every state they do business in.