After having decided that forming a new entity (as opposed for example to buying an existing business) is the best solution to do business in the US, a businessman is confronted with the decision of where (i.e., in which jurisdiction) to form a business. This is an important decision because the choice affects which law is applicable to your entity and corporations and company law vary from jurisdiction to jurisdictions.

The differences should not be overstated, however. Variations exist and sometimes are quite important, but there are common principles that apply in most states. One basic principle is that forming an entity in the US (whichever state you choose) is simpler and less expensive than in most of the Civil law countries (take France or Italy for example). See here for a chart that compares the number of procedures, time and cost for a small and medium-size limited liability company to start up and formally operate.

Taxation also varies from state to state. However, taxation difference should not be overestimated. The biggest part of your yearly taxation is federal taxation, which is imposed regardless of the state in which you make business for the simple fact of making business in one of the fifty states (see here for more information) – and this part does not vary state by state. We will discuss later the two possibilities of taxation that a LLC has (as a partnership or as a corporation). This decision has important consequences at a state tax level.

This article aims at providing some (but less than all) factors useful in making a choice among jurisdictions. While you might want to consider several options before forming your entity, this article focuses on the most popular jurisdictions that you might have heard about: New York, Delaware, Nevada and Wyoming.

Which are the most important factors to consider in choosing the state of formation?

(1) Situs of Business (i.e. where will you be conducting your business), which is not dispositive but it is recommendable to form your entity where you perform your business. If you do not know where you will be principally conducting your business, you or your key employees may have a personal preference for a certain place where to live (example New York or Miami). This is something that you might want to take into account before forming an entity because an employee’s presence in a certain jurisdiction is often enough to create (tax) nexus with a jurisdiction (so you may end up to be forced to file two tax returns, one in the state of incorporation and the other in the state in which you have nexus);

(2) “Choice of law” factor (i.e. the law that applies to your entity because you have formed it in a certain jurisdiction);

(3) Easiness and costs of forming your entity;

(4) Privacy/confidentiality rules (i.e., extent of required disclosure);

(5) liability protection for members/shareholders (i.e., whether or not they are protected from losing their interest for personal debts);

(6) Personal liabilities of shareholders/members and directors (i.e., whether they might be forced to pay for entity’s debts of for malpractice);

(7) taxation advantages/disadvantages (including state tax programs, like tax credits and grants, which sometimes require you to be a local entity to be granted).

Factors from (3) to (7) are actually particular aspects of factor no. (2). However, because they are particularly important in the choice of the jurisdiction we deal with them separately.

The relevance of the above factors depends on the importance that you attach to a certain aspect. For example: if you do not mind whether information related to shareholders or directors become public, the privacy factor is less important than the others.

A good way to approach this would be to have a checklist (let’s call it a legal diagnostic checklist) in which you flag the factors that repute more important for you. This will help your lawyer advising you.

1. Situs of business.

As a general principle, unless you have special reasons not to (other reasons being the importance attached to the other factors), you may want to consider first to form an entity where you plan to have your principle place of business because you will have to qualify to do business in this place anyway (i.e., basically performing a series of steps which are very similar to forming an entity there) and you will end up with multiple reporting requirements and multiple fees.

If you are an out-of-state entity that transacts business in another state, you are “foreign entity” (corporation or company). For example, because they are easy to form (and for other reasons that we will be discussing here), it is quite typical to form a Delaware, Nevada or Wyoming entity and then use this entity to transact business in other states. You should consider that every jurisdiction has its own definition of “transacting business” in the state. While many states have adopted the Model Business Corporation Act Section 106 or the Revised Model Business Corporation Act Section 15.01, which contain a list of what is not considered to “transact business” in the state (example South Carolina), the definition of what does constitute “transacting business” varies. See this memo of NY Secretary of State that gives guidance on when it is appropriate to qualify to do business in the State.

If you “transact business” in a certain jurisdiction, you are required to qualify to do business here (the relevant rules are referred to as “qualification statute”). The requirement responds to the interest of protecting citizens from abuses and to protect local businesses from unfair competition of “foreigners”. There are sanctions for omitted qualification. Often the sanction is only disability to sue (even on a negotiable instrument) until you perform the necessary steps to qualify– see this old but interesting article on the point – but a more harsh penalty for omitted qualification is provided (example Connecticut assesses – and actually enforces – a $300 penalty for each month, or $3,600 for each year for transacting business without a certificate of authority, plus fees and interest. See this article for sanctions for omitted qualification in California.

So if you know that you main of business will be in a given state, and your only reason to form an entity in another is easiness and costs, you may want to think twice.

2. “Choice of law” factor.

While this might end up to be an important factor in the future of your entity (for example if a litigation between the partners ensue), the analysis that you would need to do to choose “the most suitable law”, might be more than a small start up generally wants to do. That does not mean that you could ignore that because by choosing a jurisdiction you choose the law governing internal affairs of your entity and the contract law.

(i)As for the law governing internal affairs, consider that this includes both the statutory law of the jurisdiction of formation (which generally means which corporation law or LLC Act applies) and the common law as emerging from the case law of that jurisdiction. As for the corporation law or LLC Act, consider that parties can modify the majority of statutory provisions. You may wonder whether it is necessary to have an operating agreement (in case of LLC) or Bylaws (in case of a corporation). You will listen that it is never a good idea to leave your entity at the mercy of the default rules. However, the reality is that it depends on your risk propensity. You might say that if you are forming a single member LLC for a small start up and you are a shoe string budget, you may consider deferring the drafting of the operating agreement or bylaws to a later moment and temporary rely on the default rules. What I would not recommend doing is pulling down a form from the internet and use it for your company. Because it has been prepared with another situation in mind, it is unlikely that such a form will suit your needs) and it is more likely to create issues than to solve them. If you prefer saving on legal fees, it is much wiser to rely on the default rules of the jurisdiction of formation, as interpreted by the case law. However, you should consider the following: there are jurisdictions that have very well developed business rules, while other jurisdictions might not have it. You generally do not want to select a jurisdiction that has not enacted a corporate act or LLC act – as the case may be – because in the absence of statutory law, you will have to rely solely on case law, which can be incomplete. Also a corporate law which changes a lot, should make you pause to think. For example, while it is true that Delaware has the most developed business law and the most qualified business courts of the nation, Delaware has also an ever-changing corporate law and this forces you to continuously monitor the situation to be sure to keep your business affairs consistent with the law (for example, Delaware has just introduced a ban on bylaws attorneys’ fees provision for derivative action – here and here).

With specific reference to a LLC, consider that forming an LLC in one jurisdiction that has adopted the Revised Uniform Limited Liability Company Act (“RULLCA”) (or its predecessor the Uniform Limited Liability Company Act is generally easier than forming in jurisdictions that have not. Just to mention some states: California, Florida, New Jersey and Pennsylvania are Uniform LLC Act states.

(ii) As for the contract law of the jurisdiction, because a corporation and an LLC are creatures of contract, by choosing the jurisdiction you also “choose” the body of contract law applicable to the entity’s internal affairs, including very critical issues such as “parol evidence rule” (which can be stricter or loser depending on the jurisdiction), statute of fraud (whose scope varies in the several jurisdictions), and the “no oral modification” (which also varies and in some states it is governed by statute).

For more information, Francesca Giannoni-Crystal