Why form a corporation in Delaware?

Dear Alex:

I am starting a new business, and a friend told me I should incorporate in Delaware. I’ve heard this before but do not understand why this is recommended.Do you think I should form a Delaware corporation?

It is true that many companies choose to incorporate out of state, in more “business-friendly” states such as Delaware or Nevada, and for a variety of reasons.

For most small businesses in California, however, incorporating out of state is an unnecessary inconvenience and complication to conducting business. For some business types, however, it may make sense and might even be critical to the future success of the business.

Frequently, people tell me they want to incorporate in Delaware for “tax purposes.” While Delaware’s franchise tax is frequently lower than California’s minimum of $800 per year, foreign corporations doing business in California must still pay the $800 franchise tax to the state of California, as well as other registration fees.

Moreover, even if the out-of-state venue in which you elect to incorporate has friendlier tax policies, California’s State Board of Equalization is highly proficient at collecting tax on foreign corporations doing business in California, for all of their California business activities – just as if it were a California corporation conducting such activities.

Unless the corporation has a significant amount of out-of-state revenue generation and business activities that are not managed or the result of work performed in California, your business is unlikely to find any tax haven by incorporating out of California.

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Another viable reason for incorporating in Delaware is due to the body of law that Delaware has developed for their corporations, and the protections Delaware law offers to business management and directors.

Delaware has a long history of being a desirable location for corporations to form, and as such the state has developed a significant body of law that provides predictability and protection for the business owners. This is also desirable for a large company; however in a small-to-mid-sized business in which the owners are also frequently the only shareholders, this is of little value.

The most compelling reason for a small California business to incorporate in Delaware is often for the sake of appealing to financiers from venture capital and angel investment firms. Small businesses structured to grow via funding frequently incorporate in Delaware to appeal to venture capital firms.

Venture capital firms desire the benefits of Delaware’s body of corporate law; they prefer to keep consistent applicable laws across their entities to the extent possible to more readily stay in compliance with those states’ laws; and if they anticipate the company may file for an IPO in the future, at that stage Delaware’s combined benefits may become very important.

For your small business, however, unless you are a startup intending to seek rounds of venture funding, Delaware may not be as desirable as it is frequently made out to be.

Alex Myers is a business attorney with Myers & Associates in Napa. Reach him at alex@myers-associates.com or 707-257-1185. The information provided in this column is not intended as legal advice, nor does it create an attorney-client relationship. The information is not a comprehensive analysis of the law — if you need legal advice, contact an attorney.

This column originally ran in the Napa Valley Register on December 8th, 2015. You can read it on the Register's website here: "Why form a corporation in Delaware?"

Should I Create an LLC for Real Property?

"I own a personal residence and a rental property. I was told to put the rental property into an LLC to protect my personal residence from the liability of the rental property. Is this a good idea?”

This is probably good advice. There are benefits and drawbacks to LLCs (limited-liability companies), but if you are planning to put your rental property into a limited-liability entity to protect your other personal assets, an LLC is usually the best choice. There are other entities that offer limited liability, such as C-corporations and S-corporations, but the tax consequences of putting real estate into a corporate entity like those can be disastrous.

When you contribute real property into an LLC, the liabilities associated with that real property and its business activities are cut off from the personal assets of the owners (called “members”) of the LLC. People who have multiple properties or other assets (for example, investment accounts or ownership of a business) can benefit greatly from separating their rental properties from their other assets by use of LLCs.

Of course, the property within the LLC is still subject to the liabilities of the LLC. If there is a lawsuit related to the property held in the LLC, the property itself can still be subject to any judgment associated with that lawsuit.

While the principles of liability protection by an LLC are appealing, they aren’t without limitations. Individuals can always be held responsible for their own acts of negligence, so keeping property in an LLC is does not always protect the members from their own bad or negligent actions. Additionally, much of the financial protection that LLCs offer can be accomplished through insurance.

Not only will lenders require minimum insurance coverage, but in the event of a lawsuit or claim, it is better to have cash paid out of an insurance policy than be forced to sell the property to pay for money damages.

A problem with relying solely on insurance as a protection from liabilities is that insurance policies have limits in the amount of damages they cover, and exceptions and limitations on the types of damages that are covered. Best practices call for property owners to both hold the property in an LLC, and to carry adequate insurance.

There are other drawbacks to an LLC. One of those drawbacks is the annual minimum Franchise Tax that the state of California assesses against LLCs and other corporate entities, which is currently $800 per year. For some, the Franchise Tax may make the LLC not worth the cost. Additionally, many lenders won’t lend to an LLC directly and at minimum will require LLC members to personally guarantee the debt.

Alex Myers is an attorney with Myers & Associates in Napa, and can be reached at alex@myers-associates.com or at 707-257-1185. The information provided in this column is not intended as legal advice, nor does it create an attorney-client relationship. The information is not a comprehensive analysis of the law — if you need legal advice you should contact an attorney.

This column originally ran in the Napa Valley Register on March 3rd, 2015. You can read it on the Register's website here: http://napavalleyregister.com/business/should-i-create-llc-for-rental-property/article_21e4c0ce-5cf3-5875-a9e8-7e3477beea82.html