For those with short attention spans, let me cut to the chase. No, you should not incorporate in Delaware or any other state tax haven, UNLESS it’s the state you live in. For those that want to understand why, keep reading. In this article, we will be using Delaware as the primary state to compare to, but of the points can be applied to other supposed tax advantageous states.
It’s important to note that the use of entities in different states is a tax reduction strategy employed solely by corporations. By corporations, we mean C corporations (i.e., Exxon, Microsoft, Coca Cola, etc). The reason that C corporations can benefit from these strategies and you, the independent contractor cannot, is because C corporations pay tax at the entity level before paying out dividends and salaries. Which the recipients then have to pay taxes on as well.
Delaware’s General Corporation Law is one of the most flexible and well known corporate laws in the country. The state legislature updates its corporate laws and policies often, to keep it clear and predictable for corporations. While Delaware is extremely corporation friendly, its corporate income tax (rate is actually above average). Although, other aspects of Delaware’s corporate law facilitate businesses in reducing their tax liability.
The Delaware Loophole
Many businesses that are incorporated all over the country exploit the fact that Delaware doesn’t tax royalty payments. Royalty payments are income generated by intangible assets, or something that does not physically exist, but still has actual value. (I.E. brand recognition, a logo, a song or jingle.)
To explain how corporations take advantage of this, I will be referring to 2 hypothetical corporations. The first, Corporation A, we will say was formed in California. The second, Corporation B is formed in Delaware.
So, to take advantage of the Delaware Loophole, corporation A forms corporation B in Delaware. Then Corporation A transfers ownership of an intangible asset, to corporation B. Corporation A then pays Corporation B royalty payments for the rights to use that intangible asset. The rates of the royalty payments are designed in such a way that almost all of corporation A’s income is paid to corporation B in the form of royalties. Because Delaware doesn’t tax royalty payments, they avoid taxes on that income altogether.
The Court of Chancery
Normally the court system isn’t a determining factor when choosing where to incorporate, but in Delaware it is. Delaware uses a unique court called the Court of Chancery that focuses solely on legal issues for corporations. The Court of Chancery uses judges that are well versed in corporate law to rule on cases, instead of juries.
Rulings that would take on average 2-3 years to resolve in the civil courts of other states, can be resolved in an expedited fashion, in the Court of Chancery. This fact is especially important to big corporations, as a looming suit or legal dispute can damage the corporate stock, and discourage new investors.
State Corporate Income Tax
Another reason why Delaware is so popular to form entities is, there isn’t a state corporate income tax for companies that form their entities in Delaware, but aren’t physically located there. This is a great advantage for C corporations, as they are taxed at the corporate level, meaning any revenue the corporation receives is taxed at the entity level before it is distributed as salary and dividends.
However, for a small business owner with either an LLC or an S corporation, this provides no tax advantage whatsoever. Both structures are flow-through entities, where the income flows through the business to you, to be claimed on your personal return. LLCs and S corporations aren’t even subject to corporate income tax (Does your city have a local sales tax? Click here to check).
The bottom line for small business owners is this: just because you form an entity in Delaware doesn’t mean you are avoiding taxes in the state you are actually transacting business in. You will still have to pay income and self-employment taxes to your home state, which defeats the purpose of forming an entity in Delaware or any other state.
On top of that, because you formed in Delaware, you would have to register as a foreign entity in any state in which you conduct business. So if you factor in the initial and ongoing costs imposed on corporations and LLCs, plus foreign entity costs and fees in the other states you are conducting business in, and the fact that it doesn’t generate any tax benefit anyway, it becomes evident forming your entity in Delaware isn’t an advantage at all.
I hope you learned more about why corporations form in Delaware and why you shouldn’t. If you are still wondering, what state you should incorporate in, the answer is: it depends. We recommend talking to your CPA, so you can choose the best state to form your business. The best state is one that takes out any complicated structuring you would have to deal with by forming elsewhere, and keeps your ongoing costs and fees to a minimum.
Independent Contractor Tax Advisors is dedicated to implementing tax strategies that streamline your business and save you money. Contact us today for a free tax consultation to find out how we can save you money!
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