The Article I Should’ve Read Before Forming My Delaware LLC
This article should not be considered legal or tax advice. Please consult with a CPA or attorney to get advice specific to your business.
There’s a lot of noise on the Internet when it comes to figuring out whether or not to form your limited liability company (LLC) as a Delaware LLC, or organize it in the state you call home.
Simple time tracking that syncs with payroll.
I should know.
Over the past decade of living in California, I’ve operated multiple sole proprietorships. And at the exasperation of both my accountant and lawyer, I’ve also owned both a California and a Delaware LLC. (Whoops.) I’ve experienced first-hand the pros and cons of forming a Delaware LLC while living in California.
To make matters more confusing, tax professionals and attorneys from around the country advocate on both sides of the fence. Some say a Delaware LLC is the way to go, while others write it off as having only marginal (if any) benefits for some types of business owners.
I had no choice but to get to the bottom of this question. So I did a lot of research. I read the laws, flipped through the history books, and interviewed attorneys and tax professionals that work specifically with LLC owners.
And now, the resources you need to answer this question are inside this article. I also packed in a bunch of other things to think about as you’re deciding how to incorporate your business.
Before we share this LLC goldmine, let’s first answer the question that brought you to this page.
So should I form a Delaware LLC?
If you live outside of Delaware, then my answer would be no—forming a Delaware LLC would probably not be the best decision. Based on my research, my opinion is that it’s generally best to form your LLC in your home state.
CPA Logan Allec, owner of the personal finance site Money Done Right, explains the biggest con. “Even if you form your LLC in Delaware, you’ll still need to register your company as a foreign entity with your home state’s Secretary of State office.”
That extra step of registering as a foreign entity costs valuable time and additional filing fees—both upfront and on an ongoing basis. This is because your LLC technically continues to operate in your home state and Delaware, where it’s registered.
There are, however, two giant questions to ask yourself:
- Is it important for your LLC to keep its ownership anonymous? (Do you want others to know that you own your LLC?)
- Does your line of business have a high risk of future litigation?
If you’re nodding “yes” to these two questions, then a Delaware LLC may possibly be a better move. Here’s a flowchart that sums it up:
While Delaware does indeed have one of the most business-friendly legal systems in the country and no taxes on out-of-state corporate income, the additional complexity and filing requirements that come with operating a Delaware LLC when living and doing business in another state isn’t worthwhile in my view.
Let’s go back to that foreign entity point. When you operate a Delaware LLC that does business in a different state (most likely, your home state), you’ll need to register as a foreign entity. Registering requires additional filings, fees, and more yearly tax obligations—making this an option that’s rarely worth it.
If you live in the state of California, it’s a particularly bad idea to form a Delaware LLC, because you’ll be seen as doing business in California no matter where your company is formed. This ultimately translates into either:
- Forming an LLC in California (the cheaper option); or
- Registering your Delaware LLC as a foreign LLC in California (which costs more both initially and each year).
As we touched upon though, there are two exceptions to keep in mind when making this decision:
- Privacy: Delaware is just one of four states that allow LLCs to keep their ownership information anonymous and private while still receiving all the same treatment and benefits as any other LLC. If that level of confidentiality is essential to you, then a Delaware LLC could be a good option.
- Legal action: If you’re starting a company where regular litigation is a natural part of doing business, such as developing, licensing, and defending a large amount of intellectual property—or you simply expect to engage in corporate litigation at some point in the future, then Delaware may be your best choice for forming an LLC. This is because Delaware has a special court system, called The Delaware Court of Chancery, where Delaware-based companies can get legal disputes addressed quickly and expertly by judges who specialize in corporate law, without involving juries.
If these two factors aren’t crucial to you, then I’d suggest simplifying your LLC formation process and ongoing tax obligations by organizing your company in your home state.
Corporate lawyer and accountant, Kimberly DeCarerra, who’s represented companies of all sizes throughout her career, echoes similar sentiments.
DeCarerra explains, “For new businesses and particularly small businesses, I generally recommend they organize an LLC in their home state. Even if you organize in Delaware, you’ll still need to pay fees in your home state to register as a foreign business authorized to do business in the state.”
On top of just the initial filing and fee obligations associated with registering your Delaware LLC as a foreign entity in your actual state, you’ll now also be on the hook for paying annual franchise taxes in both Delaware and your home state where you’re actually doing business.
For most small businesses, I don’t think a Delaware LLC makes sense. The math just rarely works out in your favor.
Plus, you’ll distract yourself from the more important work of actually getting your business off the ground and attracting paying customers.
Now, let’s explore the nuances of whether or not a Delaware LLC is a good fit for your specific business. We’ll start with a quick crash course on what exactly an LLC is, and how Delaware turned into the go-to state for forming a business entity.
What is an LLC?
An LLC is a way to structure your business where, as an owner (referred to as a member), you’re not personally responsible for the debts of the business.
The key benefits of an LLC include:
- Helps you avoid double taxation (in most states)
- Protects your personal assets from lawsuits and creditors
Compared to a sole proprietorship, the other common entity for a one-person business, an LLC does not leave you personally responsible for the debts your business incurs. It also provides additional tax and legal benefits beyond what you get as a sole proprietor.
How did Delaware become the incorporation capital of America?
As per the Delaware Division of Corporations, more than a million businesses, including more than 66% of the Fortune 500s, have chosen this tiny state as their home.
Numerous high-profile companies (including the likes of Google and Coca-Cola) incorporated in Delaware because of its business-friendly laws and policies, tax system, and corporation court, which we’ll get into here.
Delaware was the first US state to vote in favor of the Constitution, and it was also one of the first states to adopt a General Corporation Law. From 2002 to 2017, every edition of a survey by the US Chamber Institute for Legal Reform (ILR) has declared Delaware as having the most business-friendly legal climate. In the 2017 ILR ranking, Delaware lost its spot to South Dakota and fell to the 11th spot.
Delaware’s Court of Chancery
Still, Delaware continues to offer one unique legal advantage to businesses through its Court of Chancery. The Delaware Court of Chancery is a trial court that dates back to 1792, and doesn’t have a jury.
This legal system originated in England, as you can see in this painting of the Court during the reign of King George I:
Delaware’s Court of Chancery has a history of being an exclusive equity legal system that handles only lawsuits and petitions requesting remedy in the form of injunctions, or court orders, rather than damages. The judges who rule on cases are called chancellors and are well-versed in corporate law.
Here’s why we’re telling you this.
The Court of Chancery makes it easy to deal with legal disputes as the owner of a Delaware LLC.
On average, it can take two to three years for a civil trial to resolve in the US. But if you’re a Delaware-based company, you can expect a resolution for your business dispute in weeks.
You can even expedite appeals to the Delaware Supreme Court. (Just realize that you’ll need to be physically present in the state for any court dates.)
In most state civil courts, corporate cases are pushed to the bottom of the backlog. Also in most states, juries pass judgment on business decisions without insight into the inner workings of companies. This means that judges and lawyers need to study up on corporate law for every trial, which adds unpredictability and delays to corporate cases.
As more businesses incorporate in Delaware, it leads to more corporate trials. Therefore, the state now has a large body of case law to help business owners figure out how to handle legal issues.
How would you like to know beforehand if your business should fight a corporate lawsuit or just settle? The case law will help you and your lawyer decide.
With a large number of precedents to draw from, incorporation in the state may be a smart move if you expect to deal with litigation. You can use the consistency of law and speed of resolution to your advantage.
Filing a Certificate of Formation for a Delaware LLC
Compared with other states, Delaware requires a minimal amount of information to form an LLC. The formation documents (called the Certificate of Formation) don’t require your personal information, which means your identity is not made public.
In addition, LLCs in Delaware are not required to file annual reports with state authorities detailing the activities of the prior year.
- The Delaware LLC formation costs include a $90 filing fee (as of the publish date of this article) that’s paid to the Division of Corporations.
- You also need to pay a $300 tax on June 1 every year through the Delaware Division of Corporations website. (You can pay for expedited services and get an LLC formed on the same day—seriously—by paying additional fees. Here’s the fee schedule.)
This is the information you’ll need to include on your Certificate of Formation:
- Your LLC name
- Your registered office address
- Duration of LLC (only if you have a predetermined dissolution date)
- Date of formation
- The name and address of your registered Delaware agent
- Name and signature of the person authorized to form the LLC
This is what the certificate looks like:
Your name will appear under the ‘Authorized Person’ section if you complete the Certificate of Formation yourself.
That is, unless you want to take advantage of the anonymity offered by the Delaware Limited Liability Company Act. If that’s the case, you’ll need to hire a Delaware registered agent who can prepare the Certificate of Formation for you.
Your registered agent’s name will be listed as the authorized person. In fact, you don’t even need a US bank account in order to register this way, which means the ownership of the company is shielded. According to a senior adviser at the Tax Justice Network, Delaware was the single largest source of anonymous corporations in the world in 2012.
You can use the incorporation services of a registered agent like Stripe Atlas to file a Certificate of Formation for your Delaware LLC. You can also explore more options for Delaware registered agents here.
Note: You don’t necessarily need an LLC operating agreement while filing for the Certificate of Formation in Delaware. It’s simply an internal document meant to guide an LLC’s members. However, to avoid conflicts in the future, many lawyers I spoke with highly recommended that business owners spell out the ownership and operating procedures of your LLC through an official agreement.
Tax Exemptions in Delaware and the “Delaware Loophole”
A recent academic paper in the Journal of Financial Economics regards Delaware as a domestic tax haven. This is no surprise because the tax laws of the state give business owners many ways to lower their tax bills.
Let us count the ways:
- You don’t need to pay income tax if your company operates outside Delaware.
- Your in-state purchases are not subject to taxation because there is no sales tax in Delaware irrespective of whether you are physically located in the state or not
- Delaware doesn’t impose a property tax, so you can own office space by simply paying county-level real estate tax (which is relatively low)
- The state doesn’t levy fees for value-added taxes (VAT), inheritance tax, or inventory tax.
- Lastly, the “Delaware Loophole.” Delaware doesn’t tax the gains from fixed-income or equity investments. This has led to corporations establishing shell companies in Delaware (known as Delaware holding companies) and collecting income from intangible assets, like patents, for example.
The Delaware Loophole helps companies avoid tax liabilities in other states by moving parts of their businesses (including trademarks, copyrights, patents, and investments) to Delaware.
Naturally, these tax advantages are more appealing to large companies—not your average small business owner.
Delaware holding companies are able to collect income from intangible assets like patents and trademarks without paying any taxes on that income. Then, the parent companies usually pay a royalty to their Delaware subsidiaries to lease back these assets.
In the states where these companies actually conduct business, these royalties result in income tax deductions. Even more, these shell companies are able to funnel tax-free profit back to their parent companies through dividends and loans.
A famous case of the Delaware Loophole
One creative case that got a lot of scrutiny for this practice came from Toys “R” Us. (It even attracted a lawsuit.)
They paid a Delaware subsidiary in order to place the name Toys “R” Us on their retail stores. The company then deducted the money they paid to their Delaware subsidiary from their in-state earnings in other states, which reduced their tax burdens there.
At the end of the day, it was obvious that Toys “R” Us was moving money from other states to Delaware, where, because their trademark is an “intangible asset” in that state, it isn’t actually taxed. The company ultimately lost the lawsuit in one state, but was allowed to continue using this practice in the other states it operated in.
In 2013, a study found that firms using this Delaware tax strategy reduced their state income tax burden between 15% to 24% compared to other companies. That translates to an increase in net income by 1.04% to 1.47% a year, which can be substantial on large scales.
Now, let’s turn our eyes to another state: California. The next section explains the reason I think California business owners are the worst candidates for forming a Delaware LLC, along with a few commonly asked questions.
Why Delaware LLCs are least suitable for California small business owners (like me)
California boasts the largest economy in the US, which may make the state seem like it can turn your business into a money-making machine. However, the heavy taxes imposed by the state of California can make it difficult for many small business owners to get off the ground.
A study by Quickbooks put California as the top taxed state with a maximum income tax rate of 13.3% and a sales tax rate of 7.5%. The state also imposes both business and personal taxes on LLC owners. It’s one of the few states that implements double taxation, which is what makes it such a high-cost state to do business.
Because of California’s double taxation laws, I originally started my blog and organized it under a Delaware LLC, thinking I’d be able to lower my tax bill at the end of the year. However, that decision turned out to be ill-informed due to the requirement that I register my Delaware LLC as a foreign entity in the state of California (my home state).
Fast forward to today. I’m now going through the process of deciding whether to convert my Delaware LLC into a California LLC—or to close my entity and open a new one in California.
Interestingly, on January 1, 2014, California enacted a new LLC law called the California Revised Uniform Limited Liability Company Act (RULLCA). It significantly altered the rights and expectations of members and managers of an LLC. (If you own or co-own an LLC, that’s you.)
Under RULLCA, the members of your LLC are given “freedom of contract,” so in case of a dispute with another member, California courts may not respect your operating agreement. It further complicates doing business in the state by adding an element of legal unpredictability if there are ever disputes between operating members.
The only other solution is to get creative. (Be sure to seek the counsel of a corporate or tax attorney before even thinking of wading into these muddy waters.)
You could live a short amount of time each year in California and form your LLC in a neighboring state like Nevada, where they have no income tax and the fees are more forgiving. But that’s risky, and not easy.
Ultimately, the advantages of forming a Delaware LLC are no longer what they once were.
Forming an LLC in your home state will likely be much less complex, even in California, and it will come at a lower cost both when starting up and on an ongoing basis.
If you live in California and want the state to remain your primary residence, I think the best option is to form a California-based LLC.
On the other hand, if you’re not tied to living and working in California, you can greatly reduce your taxable income by establishing residency and living in a neighboring state like Nevada and forming your LLC there.
Frequently asked questions about California LLCs
Here are the answers to a few of the most frequently asked questions regarding both LLCs and registering an LLC in the state of California.
Does a Delaware LLC have to pay California taxes?
Yes, if your Delaware LLC is operating in California, then you’ll need to pay California taxes on your company income, on top of your Delaware taxes. That includes a minimum $800 franchise tax.
You can read the details on the fee schedule in our California LLC tutorial. Note that you’ll also need to complete the process of filing (and paying for) foreign qualification for your Delaware LLC if your business operates in California.
Should I register my LLC in California (where I’m a resident) or Delaware?
Put simply, if I had a chance to do it over, I would register my LLC in California where I’m a resident and plan to do business. Not in Delaware. (Been there, done that.)
If you register as a Delaware LLC and are doing business in California, you’ll pay annual franchise taxes in both states. In California, that equates to a minimum annual franchise tax of $800. If you’ve chosen to instead treat your LLC as a corporation in California, then you will also pay franchise taxes at a flat rate of 8.84% of your company’s net income.
|California Annual Franchise Tax||Delaware Annual Franchise Tax|
|$800.00 (minimum)||$300.00 (flat)|
In the state of Delaware, you’d still need to pay a flat annual franchise tax of $300 because that’s where your business is registered. Note though that Delaware has zero sales tax. You’re only charged a gross receipts tax on the total gross revenue of your business that ranges from .0945% to .7468%, depending on your business activity.
Now, if you go ahead and register your LLC in California, then you’ll still need to pay the annual minimum franchise tax fee of $800. If the annual gross revenue of your LLC exceeds $250,000, then you’ll need to pay additional annual fees. And if your LLC income exceeds $250,000, you’ll also be responsible for paying an estimated LLC fee payment in four installments throughout the year.
California LLC annual tax obligations
|Annual Franchise Tax||$800.00|
|If your LLC income is less than $250,000, then you are not charged an LLC fee||–|
|If your LLC income is between $250,000 and $499,999, you are charged an LLC fee of $900 (bringing the total tax to $1700)||$900.00|
|If your LLC income is between $500,000 and $999,999 you’ll pay an LLC fee of $2,500 (bringing the total tax $3,300)||$2,500.00|
|If your LLC income is between $1,000,000 and $4,999,999, you’re charged an LLC fee of $6,000 (bringing the total tax to $6,800)||$6,000.00|
|If your LLC income is $5,000,000 and above, the fee is $11,790 (bringing the total tax to $12,590)||$11,790.00|
On top of that, as a member of the LLC, you’ll need to personally make estimated tax payments throughout the year for reporting purposes.
Do you sell goods to people in California? Cool, that means you have to collect and pay sales tax. You can register for that here.
And you will also need to pay state payroll taxes if you’ve hired employees for your LLC. Further, you’ll withhold and pay employee income taxes to the California Employment Development Department (EDD).
It can become a lot, I know.
Check out our comprehensive guide to forming an LLC in California and chat with an attorney whenever you’re in doubt.
Do I need to register my Delaware LLC as a foreign entity in California?
Yes, if you plan to do business in California, then you first need to qualify or register as a foreign business entity.
Specifically, you’ll need to file the LLC-5 application form with the California Secretary of State.
To stay in good standing with the state, you’ll also need to appoint a registered agent in California to be on file at all times.
Remember, this will now require that you pay California franchise taxes each year.
Note that some activities like selling your products through the use of independent contractors based in a particular state are actually exempt from the definition of “doing business.” Be sure to read carefully about what your registration obligations will be.
Frequently asked questions about Delaware LLCs
Time to fly out of California. Below are answers to a few popular questions about LLCs and registering an LLC in the state of Delaware.
Can I write off losses and expenses in the same way with a Delaware LLC?
A Delaware LLC works as a pass-through entity for taxation purposes. It means that profits flow through to owners and are taxed under the individual income tax, rather than being subject to a corporate tax—and any losses can also be claimed on the owner’s personal income tax returns.
You can also include startup costs under qualifying expenses of the business during the first year.
Does my tax rate depend on my home state?
If it doesn’t, is there a tax benefit to forming my LLC in Delaware instead of my home state?
The two major advantages of Delaware are that the state imposes zero sales tax, and it allows profits from intangible assets like trademarks, naming rights, or other intellectual property to go untaxed in the state.
Plus, the tax savings through the Delaware Loophole are permanent.
Is an LLC the right choice for my startup?
If your startup plans to raise capital and go public in the future, then an LLC is probably not the right fit. You may want to consider taking the C corporation route, which still allows you to protect your assets from creditor claims.
However, it creates a complex taxation structure because your business is first taxed at the corporate level when the company makes profits. Further, the owners (called shareholders) are taxed again when the profit dividends are given.
You can get over the double taxation in a corporation by filing for S corporation status, but that entity limits you to 100 shareholders—though that’s only a problem if you plan on offering equity to a large number of employees or investors.
You can read more about LLCs in this overview.
Are there any cases where registering a Delaware LLC is better than forming an LLC your home state?
From my perspective, the short answer is no.
I think it’s usually best to form your LLC in your home state for the vast majority of people and use cases since that’s where you’re legally doing business. Forming an LLC in a state like Delaware, Nevada, or Wyoming usually ends up costing much more and creating more filing requirements in the long run.
There are two exceptions to consider:
- Non-US residents can choose to form an LLC in any state
- Real estate investors sometimes form a parent LLC in Wyoming. The Wyoming LLC then owns a child LLC that’s set up in the state where the property is
Ultimately, if you live in the state of California, you’ll be considered doing business in California no matter where you form your LLC. This means you’ll need to either form your LLC in California from the beginning—or register your out-of-state LLC as a foreign LLC in California.
The latter results in additional fees and filing requirements, which means it’s unnecessarily burdensome for the majority of business owners and situations.
The verdict? You may want to register your LLC in your home state
While forming a Delaware LLC once gave you a sense of predictability, tax savings, and a business-friendly court system, those advantages have diminished over time as other states have caught up.
On top of that, a Delaware LLC will be more costly when it comes to your ongoing tax obligations. It will also give you a taller stack of paperwork to file upfront.
An LLC based in your state of residence (even if that’s California) will help keep things simple. And when it comes to forming a business, sometimes that’s exactly what you need.