Think Twice Before Forming Your Business Entity Out of State

introduction

Real scenario: a business owner called me to inquire about registering his Nevada LLC to conduct business in California. He lived and operated in California, yet he formed the LLC in Nevada because that state does not have income tax. He formed the entity using an online service - not an attorney - and had no idea what to do next. He didn't have legal advice when he created the entity, he just paid an online service to create the entity.

I inhaled deeply and hoped he wouldn't shoot the messenger. I informed him of the procedure and cost for registering his Nevada LLC in California, which he is required to do, and considering the cost of maintaining one entity in two states, he could form a new entity in California for less. Given the cost and extra paperwork, it made no financial sense to operate his Nevada LLC in California. He still has to pay state income tax to California, and he only created more work and expense for himself.

I gave him a quote with the option of: 1) forming a new California LLC; or 2) registering his Nevada LLC in California. I advised him that the legal cost of each option was roughly the same, but the ongoing/future cost of the second option was twice as high. The prospective client said he would "figure it out," and he never called back. The poor guy wasted money and made his business structure unnecessarily complicated. Sometimes my job requires me to tell people what they don't want to hear.

If you are operating your business in California and considering incorporating in one of the seven states that do not have income tax (Texas, Florida, Nevada, Alaska, Washington, South Dakota, or Wyoming), it can be tempting to form your company out of state then operate in California. By forming your business entity in a non-income tax state, you don't have to pay state income tax, even if you live in California, right? Not only is this assumption wrong, but forming the entity out of state, then operating in California will double your expenses and paperwork.

entity formation in general

Creating a legal entity is relatively simple. You complete a form and pay a fee to the secretary of state of your chosen state, then file the annual statement (called a Statement of Information in California). You have to do more than that to properly maintain the entity (a separate topic for a future article), but that is literally all you have to do to create a legal entity that has a separate legal existence from you personally. 

You must designate a person or company in the state of incorporation as your agent for service of process. This is the only person authorized to accept service of legal process, such as a summons or subpoena. 

Every year you must file an annual statement, called a Statement of Information in California, and pay a $25 fee (due bi-annually for LLCs). California's Franchise Tax Board also charges $800 a year for the privilege of operating a business entity in California - regardless of whether the entity was formed outside California. You will get a penalty and interest hit if you pay the fee late, and the state will suspend your business if you fail to pay at all. 

This process is generally the same across the states, subject to variations in nomenclature. 

registering a foreign entity

Suppose you live and work in California, but have already created an entity in another state. Regardless of whether you have a foreign LLC or corporation, you need to register the entity in California before it can do business here. If you are transacting "intrastate business" in California (a fluid and undefined term), then you must register with the California Secretary of State before transacting business. It's a safe bet to assume that if you are an LLC or S-Corporation, and you live and work in California, but formed a Nevada LLC, you need to register the LLC in California.

Here's what to do. You must submit a form and pay a fee to the Secretary of State of your state of incorporation, and request what is generally called a Certificate of Good Standing. Again, nomenclature varies among the states.

Once the Certificate of Good Standing arrives, you file an Application to Register a Foreign LLC with the California Secretary of State, along with a $70 filing fee.  Upon approval, you have to file and pay for the annual Statement of Information (due within 90 days), and you must pay the annual $800 FTB tax. 

These annual fees are in addition to the fees you must pay to the state of incorporation. You also must appoint an agent for service of process in California, in addition to an agent in the state of incorporation.

In summary, by registering your foreign company to conduct business in California, you have annual filings and fees in two states.

but what about no income tax?

Wasn't the whole point of incorporating in a foreign state to avoid paying state income tax? Unless you are personally domiciled in that zero income tax state, the answer is No! 

Consider this - LLCs and S-Corps have pass through taxation, so the profits and losses are allocated to the tax returns of the individual members/shareholders. The entities themselves don't file tax returns. If you are domiciled in California, then you pay income tax to California. Your Nevada LLC doesn't absolve you of tax liability to California.

summary

If you formed a Nevada LLC to avoid state income taxes, but you are domiciled in California, then you are going to pay income tax, and the entire purpose for incorporating out of state was frustrated.

Even worse, you will have to register your business in California (if you are transacting business here), and that entails fees and paperwork to both states. You also must submit annual filings and fees to both states, and appoint a registered agent in both states. 

In closing, if you're considering forming your LLC or S-Corp. out of state to avoid income tax, and you are domiciled in California, I hope this article gives you pause. Go speak with your tax professional to corroborate your tax savings theory. If you have already formed the entity out of state and are domiciled in California, you might consider dissolving the foreign entity and forming a new entity in your home state.

Being in business is hard enough, and you shouldn't complicate your life with unnecessary paperwork and fees.