July 10, 2013
The process of domestication is when a domiciling state will recognize an entity formed in another state and, at the request of the entity, will effectively transfer the entity into the new jurisdiction. The new jurisdiction adopts the original formation date as its formation date; hence, it is as though the entity had always existed in the new jurisdiction.
This is a novel legal maneuver – as the older method of entity transference involved forming new entities, merging the old and the new and closing down the old. Some individuals opted to form an entity in a new state, transfer all assets and liabilities into it and close the old one down. Nonetheless, these are cumbersome steps to transfer entity domicile from one state to another.
Domestication – When It Is a Convenient Tool
Domestication is a convenient tool available to common business owners when they seek to move states. For example, a business where the shareholder and operations are taking place in NY may choose to move to IN – and domesticating the entity would be the quickest form of transfer. Situations like this are clean cut – a move took place and the domicile of operations, shareholder residence and entity existence are all moved cleanly and conveniently to a new state.
When domestication occurs, Articles of Domestication (or equivalent state term in the destination domicile) would be filed, and depending on the state, either the original entity is to be dissolved or indicated that it was domesticated to another state.
Domestication – When its a Trap
State taxation can be relatively confusing when it comes to nexus, entity domicile and final taxation – especially with respect to pass-through entities (S Corps and Partnerships – where the taxable income flows to the shareholder’s income tax return). For a more in depth review of the topic, see my article “Domicile for Legal Entities – Important, Misunderstood and Overlooked.”
The bottom line to tax planning with pass-though legal entities is as follows: if the shareholder and/or operations structure is anticipated to change jurisdiction in the future, then it is wise to consider a tax and corporate-friendly jurisdiction for the initial entity formation. Currently those states are WY, DE, FL and NV. The entity would then be authorized into the anticipated state of operation – and when a move or expansion takes place, the entity would be either authorized in the next state or withdrawn from the original. Taxation follows the state of business operation, secondarily shareholder residence and finally domicile.
The question then becomes “Why not form in the first state – and domicile to a tax and corporate-friendly jurisdiction when the time comes?” That is a valid assumption – and works generally in one instance – when there is a clean move from the original state to another. If the picture is going to be complicated by admitting additional partners/shareholders, expanding into other states, or the shareholders plan on moving states at any time, then the costs of forming in the original state and domesticating become higher.
These costs increase as the entity must be domesticated in the new jurisdiction, the original dissolved and then the domesticated entity authorized back into the original state. Effectively, the company ends up spending 50% more in overall entity maneuvering than forming in the friendlier jurisdiction first and authorizing into the state of operations. There is a caveat in that some states allow a company to make a filing and convert from a domestic (in-state) entity to a foreign (out of state) without having to dissolve and re-authorize. In those instances, costs are not as high as the gyrations described above.
The fundamentals behind best practice with entity formation have to do almost exclusively with planning. Entity formation and tax matters with entities are either permanent or semi-permanent decisions. They require entertaining a vision of where the founder of an entity sees the entity going, and forming it as such to accommodate the full range of options. Planning for the future is best practice with entity decision-making. Having 50 different regulatory agencies sanctioning entity formation in one country is admittedly challenging as no federal-level entity options exist.
A principle of planning in many contexts is that what costs less in the present often costs more over the long run than spending a bit more in the beginning. The same applies to entity formation. The uninformed entity owner in a majority of cases will devise a taxation and entity plan that is quickest and easiest in the present – and end up incurring costs for advisory services and entity maneuvering to fix it later. If the entity in question is intended to shield liabilities or hold measurable assets or revenue, then engaging competent advisory services in the beginning avoids costlier headaches in the long run.