Don't listen to anyone trying to sell you on the idea of incorporating out-of-state in Nevada or Delaware. More than likely, it's a scam.

As a tax lawyer advising clients across the country, I meet every week with entrepreneurs who were persuaded by an incorporation service or attorney to set up a C-Corporation in Nevada or Delaware.

It is true that almost every Fortune 500 company is set up in these two states, and they have specific reasons to do so. But for the average small-business owner, this is a waste of money and potentially risky. Unless they are doing business in Nevada or Delaware, most small business owners are unlikely to obtain any tax benefits or additional asset protection.

Fortune 500 companies have a reason to incorporate in Nevada or Delaware because Wall Street underwriters often require them to. Incorporation rules in the two states make it easier for large public companies with thousands of shareholders to comply with some securities law requirements. Scam artists will take this fact and twist it to make small-business owners think that they, too, could benefit from incorporating out of state. But this is not the case.

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For example, I recently met with a business owner moving her consulting business from New York to California. The incorporation service she was working with sold her on the idea of spending $3,000 to set up a corporation in Delaware. But the Delaware registration provided her no benefit. In fact, the decision to register in Delaware meant her personal assets weren’t properly protected from potential lawsuits against her business when she moved to California.

My new client is an educated person with an Ivy League graduate degree, but now she was out $3,000, and the hundreds of dollars it took to dissolve the entity in Delaware and register it instead in California. It would have cost her half that amount if she had set up the proper entity in the correct jurisdiction in the first place.

Many U.S. small-business owners want to avoid paying more taxes, and protect their assets. Here are some of the pitfalls involved with falling for the out-of-state incorporation scam:

  • You probably will have to pay state taxes in your state anyway. Several states, including Nevada or Wyoming, don't have personal or corporate state income taxes. Scam artists will use this fact to talk small-business owners into incorporating in these states. The reality is that if you are a resident of or doing business in a state with state income tax, then you and maybe even your company will have to pay taxes on the profits you earn anyway.
  • You could endanger your personal assets. To have your personal assets protected from business-related liabilities, your business must be registered in the state where you are doing business. If you're registered out of state, there's no protection. Your personal assets are still exposed.
  • You raise your administrative costs. When small-business owners register outside of their own state, they discover quickly they have to come back and register in their own state with a "foreign registration" document. This increases filing fees and administrative costs.
  • You can't obtain as much "privacy" as one thinks by registering in Nevada or Delaware. It used to be that strict privacy protection rules in these states allowed corporations to keep certain information, such as the identity of officers and directors, confidential. In recent years, though, Nevada, Delaware and the IRS decided they had enough of it. The states tightened their disclosure rules, so there's no place to hide anymore. What's more, because your business will need to register as a foreign entity in the state in which you do business, you'll have to disclose all of the individuals in management anyway.

Rather than believing in what sounds too good to be true, small business owners should make sure that they have legitimate certified public accountants advising them on the tax issues and lawyers setting up entities that are truly tailored to the needs of their businesses. Spending a few dollars on a quality adviser can save you thousands of dollars and hours of heartache later.

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