Delaware is the second smallest state in both square footage and population, but more than a million businesses (and over half of the Fortune 500) have formed their C-Corporations there. Why do startups choose this seemingly innocuous state to serve as their legal home base?
You may assume that the state offers lower taxes, but Delaware actually has an above-average marginal tax rate for its local corporations. These are the three real reasons why so many startups choose to incorporate in “The First State.”
Delaware C Corporations Create a Tax Shelter… Kind Of
Incorporating in Delaware is unlikely to save most small startups anything in taxes. You’re required to report your income to every state that you operate in, and if Delaware is one of them, they’ll tax you a flat 8.7% on your gross earnings.
Still, Delaware has somehow earned a reputation as a tax shelter over the years. That’s because, while individuals tend to worry just about income taxes, startup founders and large corporations have other (and often bigger) ones to worry about.
For sophisticated entities run by savvy business people, incorporating in Delaware offers these three tax advantages:
- No Income Tax on Non-Resident Corps: There is no state corporate income tax on goods or services for Delaware C-Corporations or S-Corporations that operate outside of Delaware. You’d still have to pay state taxes to whatever state you operate or transact in, but this allows you to get the benefits of incorporating in a business-friendly state without being taxed twice on your income.
- Low Franchise Taxes: Many states have annual taxes and fees called a Franchise Tax for filing and maintaining a business entity in their territory. These vary between states and can be a significant burden for fledgling corporations. California’s minimum annual fee is $800, while Delaware’s can be as low as $175.
- The Intangible Asset Loophole: Income from intangible assets, such as trademarks, loans, or equities is not taxed in Delaware. To take advantage of this, some (usually large) companies create subsidiaries in the state to hold those assets. They can then take a deduction in their state of operation for payments to those subsidiaries without having to pay tax on the corresponding income in Delaware.
Privacy, Liability, and Familiarity
Unsurprisingly, completing the legal forms necessary to register a corporation with a state can be an intensive process. At the very least, you’ll need to draft up:
- Articles of incorporation
- Corporate bylaws
- Shareholders’ agreements
- Minutes for the board of directors meetings
And the paperwork can actually become quite expensive if you have to hire a lawyer to help you get through all of it properly.
The Delaware government understands that they can attract more corporations to their state by streamlining this process. They offer expedited services so you can create a corporation request and receive your response in as little as an hour (for a fee).
Additionally, Delaware collects far less information on corporate filers than most other states.
You don’t need to share much personal data on the owners, directors or officers. That privacy makes it incredibly easy to create shell corporations in Delaware, protect your personal assets and avoid being sued.
For larger companies, like those in the Fortune 500, it’s advantageous to incorporate in Delaware simply because they expect to deal with litigation regularly and want to protect their personal assets.
Finally, the frequency with which large companies choose to incorporate in Delaware has made it an almost expected choice.
Venture capitalist firms, angel investors and corporate lawyers are well-versed in Delaware’s rules and regulations, and they’re more likely to work with a startup that’s incorporated in the state they’re all so familiar with.
Advantageous Legal Systems
Another significant benefit to incorporating in Delaware is the state’s generally business-friendly legal system.
The First State has far and away the highest revenue per capita from corporate license fees in the nation.
They know how valuable that is to their bottom line, so they’ve created an extremely favorable legal environment for corporations to encourage them to incorporate in Delaware.
This is due, in large part, to their Court of Chancery.
In most states, when a corporation is sued, it goes through a similar process as an individual:
- A judge presides over the case
- You have options to settle out of court
- Rulings are ultimately made by a jury of peers.
But Delaware’s Court of Chancery doesn’t include a jury at all. Their judges preside over each case and make their own rulings.
Their decisions often serve as the legal basis for the rest of the country’s business matters, with even the Supreme Court relying on their decisions to help them rule on similar cases.
The legal system in Delaware now has more than 200 years of historical precedents to fall back on, and since their judges specialize in business matters, they make verdicts much more rapidly than other courts.
Businesses that incorporate in Delaware, regardless of where they operate, are subject to Delaware’s laws. Their cases will be heard by the Court of Chancery, so corporations can generally expect a speedy and favorable outcome for their legal conflicts.
Drawbacks to a Delaware C Corporation
While there is a lot of potential upside to incorporating in Delaware, it isn’t necessarily the right decision for everybody. These are a few reasons you might want to consider incorporating elsewhere:
- Low Litigation Risk: Large corporations that are worried about being sued can get a lot of benefit out of using the Court of Chancery for their cases. But if your business is at relatively low risk of litigation, you’ll probably have little to no need for the advantages of the court. For instance, a local advertising agency is much less likely to benefit than Coca-Cola.
- No Intangible Assets: The Delaware Loophole is one of the biggest advantages to businesses that incorporate there. If your company doesn’t hold large notes receivable or high-value patents, you won’t be able to take advantage of the Delaware loophole. That will probably make the process of incorporating in Delaware a waste of time.
- Double taxation and paperwork: Many corporate founders assume that incorporating in Delaware will allow them to reduce their tax bill. This isn’t necessarily the case, since you will have to pay the franchise fees associated with your state of operation and Delaware. While Delaware’s franchise taxes are fairly low, paying them and filling out the state’s forms is still a cost and should be avoided if it’s not necessary.
All in all, the corporations most suited to incorporating in Delaware are large companies that operate on a national level with significant intangible personal assets.
Need Help Incorporating Your Startup?
Whether or not you think these situations apply to you, don’t try to make this decision on your own.
Before you incorporate in Delaware or any other state, make sure you consult with a Certified Public Accountant and a lawyer to help you understand the ramifications to your business.
If you’re currently trying to take this step, Founder’s CPA can help. We specialize in assisting founders like you with all of your tax and accounting needs.
Check out our free consultation so we can help you incorporate your startup today.