State Tax Incentives

April 13, 2006

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When choosing a state in which to form your business entity, you need to weigh the relative advantages and disadvantages of the laws in certain states.

Ordinarily, a limited liability company (LLC) and a subchapter S corporation will not be subject to state income taxes in a state in which they conduct no business and in which the owners do not reside. This may make it desirable to form the entity out-of-state. The owners will be subject to state income taxes in the state in which they reside or the state in which the entity conducts its business activities (usually, but not always, the same state). Delaware and Nevada, two popular states for formation of LLCs and corporations, both follow these rules.

Moreover, most states will follow the presumed tax status of the LLC (as a conduit) and the federal subchapter S tax election of a corporation (to be taxed as a conduit). However, a few states may not recognize the subchapter S election. These states may impose states income taxes on the corporation even when it does no business in the state. It also is remotely possible that a state would still treat an LLC as a corporation for state income tax purposes and impose taxes on it regardless of whether it conducts operations there.

Although these situations are unlikely to be encountered, it's a good practice to check with state taxing authorities before choosing a state in which to form the business--or form the business in a state such as Delaware or Nevada, which provides clear rules favorable to the small business owner.

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According to the most recent statistics, 60 percent of Fortune 500 companies and 50 percent of companies listed on the New York Stock Exchange are incorporated in Delaware. Moreover, many business bankruptcy proceedings are initiated there.

Consistent with this regulatory scheme, which is purposely designed to attract businesses into the state, business formation fees are low in Delaware: $160 for a corporation and $90 for an LLC.

Nevada is also gaining a reputation as a favorable state in which to form a business. A significant number of new businesses are being formed there. For example, Nevada has enacted a statutory close corporation statute similar to Delaware's statute.