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How Incorporating in Delaware or Nevada Can Hurt You

May 7, 2013
URL: http://www.entrepreneur.com/article/226549

When it comes to launching a startup, an amazing business idea will only get you so far. You’ll also need to pick which kind of business structure to form, as well as a home for your company.

In legal gobbledygook, your "business structure," or business entity, pertains to the legal form of your company and informs which protocol you’ll need to follow for paying taxes. Startups will often elect to form a partnership or a limited liability company, or LLC, which is key for consumer-facing businesses that want to limit their personal liability. Some new companies will also choose to form C-corporations. Depending on the chosen structure, small businesses can benefit from tax breaks, better audit protection and asset protection.

As a tax lawyer advising clients across the country, every week I meet with entrepreneurs who had an incorporation service or attorney take advantage of them by convincing them to set up their business entity 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, such as raising capital and securities laws required to go public. But for the average small-business owner or startup, this is completely unnecessary. Bottom line: unless you are "doing business" in Nevada or Delaware, you are not going to obtain any tax benefits or additional asset protection.

Instead, small businesses are actually exposing themselves to lawsuits in the state where they live and potentially costing them thousands in additional expenses. So while you may be thinking about paying your taxes today -- as well as how to avoid them in the future -- here are a few of pitfalls to note about setting up shop in any of the U.S. tax havens:

You may be missing the point. Large corporations have different goals than small-business owners. Big companies may need to register in Nevada or Delaware for a variety of reasons -- least of which includes saving money on taxes. A small-business owner’s needs are verydifferent and the majority of the time they can skip the complications of filing elsewhere and just register in the state they are doing business.

Related: Simple Strategies for Last-Minute Tax Filers

You may have to pay state taxes anyway. There are several states like Nevada or Wyoming with no state personal- or corporate-income tax. Scam artists will use this half-truth to talk small-business owners into filing in these states. The reality is that if you are a resident of, or doing business in, a state with state tax, then you have to pay state tax regardless.

You could endanger your personal assets. In order to have your personal assets protected from business-related liabilities, you have to 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 could raise your administrative costs. When small-business owners register outside of their own state, they discover quickly they have to also register in their own state with a "foreign registration" document, which is usually required to do business in states that don’t serve as your base of operations. This undoubtedly increases filing fees and administrative costs in the process.

You may not obtain as much "privacy" as you think. It used to be that strict privacy-protection rules existed in these states and allowed corporations to keep certain information, such as the identity of officers and directors, confidential. In recent years, Nevada, Delaware and the IRS decided they have had enough and have tightened their disclosure rules. Information that used to be protected, may not necessarily be any more.

Related: Are You Leaving Money on the Table? 5 Often Overlooked Tax Deductions

You could wind up a victim of a scam. If an advisor suggests registering in a state other than the one you are doing business, watch out. Get a second opinion and run the numbers with an independent advisor before believing you are going to see any tax benefits.

You may hurt your business in the long run. It really matters whether your business is an S-corporation, C-Corp or an LLC. Which one you choose depends on the nature of your business and other liability questions. (This is where a licensed advisor pays huge dividends in the long run). For example, if you are investing in rental real estate, it would be a major mistake to place those properties a C-corp. By contrast, if you want to lasso VC funding one day, forming a C-Corp may be the best avenue, as this entity allows you to manage multiple classes of stock.

In the end, try not to play the privacy camouflage game. It’s a game you won’t win.

What has been your experience with setting up shop in Delaware or Nevada? Let us know in the comments below.