Introduction
Delaware is a small state on the East Coast of the US, not far from major metropolitan areas (Washington DC, Baltimore, Philadelphia and New York), with less than 1 million residents. Its largest city is Wilmington, with a population of around 71,000. Apart from being the home state of President Biden, a proud Delawarean, it is famous for some advantages offered to businesses.
When establishing a subsidiary in the US, one of the main decisions that international companies need to make is which state to choose. There are many implications that need to be analyzed carefully. Unfortunately, there is quite a bit of misinformation regarding pros and cons of the different options. A lot of it is connected with the alleged advantages derived from setting up the business in the state of Delaware, which we hear often from our clients. In this article we address these issues.
For a complete review of the steps needed to set up a business in the US, we recommend our guide, tailored for international companies and entrepreneurs.
Incorporation vs Operations
It is important to understand that two key decisions must be made: where the legal entity representing the US company is created and where it will have its initial headquarters. Note that they may be different states, in which case the company will probably need to be registered to do business in both. Almost all states require that a “foreign” company (understood as one that was incorporated or formed in another state) must register before it begins operating in that state.
What state law defines as “doing business” in that state will determine if registration is necessary. The incorporation or formation of a company in a state implies its registration to do business in that state has been completed automatically. Many states do not define precisely what is meant by “doing business” and only limit themselves to explicitly defining some activities that are exempt from such consideration. In general, if the company has an office, a store, a warehouse or employees in a state other than the one selected for its incorporation, it must be registered as a foreign company in that state. For example, this means that if the company is incorporated or formed in the state of Delaware but has its main office in Florida, it will need to be registered in Florida as well, as a “foreign entity”.
Notice that the company will need to pay income taxes in the state or states where revenue is generated, regardless of where it was incorporated. Starting a business in a state different from the one in which it will develop its main activities creates a higher level of complexity and costs.
Delaware or not Delaware, that is the question
In practice, except for unique situations, the first decision that must be made is whether to create the legal entity in a state different from the one where the company will operate initially. If that is the case, Delaware is typically the state selected except for some very unique situations. Some of the main pros and cons of incorporating or forming the company in Delaware are shown below.
- Dedicated corporation court: Judges are experts in corporation law, outcomes of court cases are more predictable. Investors like this.
- Higher privacy than most other states, it does not require public registration of administrators of the company
- Simple processes in general
- Some tax savings for large corporations and investors
- Higher level of complexity and cost, since the company will need to be registered as well in the state where it bases its operations initially and will need to get a registered agent both in Delaware and the state where it operates.
- Filing fees are higher than in some of the other states
We will now dig deeper into some of the common myths found regarding the value obtained when setting up a business in the state of Delaware.
Myth #1: Choosing Delaware will save you a lot in taxes, it is a tax haven
The reality is that for most businesses who will be operating in other states there is no real tax advantage obtained from setting up their legal entity in this state. There is no state corporate income tax in Delaware on goods or services provided by corporations operating outside of Delaware, but they will have to pay taxes wherever their income is generated.
The state of Delaware does offer some tax advantages for individuals who are residents: No state or local sales tax, no VAT, no inheritance tax, no state personal property tax on real estate, no state tax on Social Security benefits.
However, the advantages for companies are not as clear. The company will need to pay annual franchise taxes and comply with reporting requirements in Delaware in addition to the taxes and fees required by the state where it operates.
For large corporations and their investors, there are certain advantages, as there are no capital shares or stock transfer taxes. In addition, there is no state inheritance tax on stock of Delaware Corporations operating outside of Delaware held by non-residents.
Myth #2: Delaware is the friendliest state for businesses
The reality is that setting up a business in Delaware is not as simple or as fast as in other states. Availability of online services for certain transactions is limited and processing times are unreliable, at least lately. As an example, we have had cases in which 24-hour premium processes took almost 3-weeks (no reimbursement of premium fee, though) and getting a simple certificate of good standing (sent via snail mail) can take several months.
Fees are also not the lowest. As an example, the cost of filing to create an LLC in Delaware is $140, but the average in the US is $139 and several states charge as little as $50. The fees for the annual report are $300, vs an average of $78 in the US and several states charging a lot less or even zero.
For corporations, the filing fee is also $140 in Delaware, vs an average of $124 in the country and some states charging only $50. In this case, the fees for the annual report are a minimum of $225, vs an average of $65 in the US and several states charging a lot less or even zero.
An advantage that is mentioned often, which has some merit, is that the Delaware Court of Chancery, a dedicated court for corporations, allows companies to resolve disputes quickly with a judge rather than a jury plus the fact that Delaware is home to some of the most business-friendly laws in the country. This is relevant for conflicts between companies and their shareholders, however if a company has a legal dispute, it may well happen in the states where it operates and the case will be managed wherever it took place, not necessarily in Delaware.
Enhanced privacy (names of officers and directors do not need to be disclosed) and flexibility for corporate and board structure are often mentioned as advantages. These may be relevant in some cases but should be compared with the conditions offered in the state or states where the business will operate.
Myth #3: Choosing Delaware for my business will be perceived negatively by some people
In the opposite direction, sometimes we have heard clients mention that, since Delaware is considered a tax haven (see above), basing the company in Delaware may be in conflict with the image that the company wants to project.
Rest assured, many large and prestigious companies, including many US subsidiaries of successful international companies are incorporated in Delaware. In fact, half of the Fortune 500 and publicly traded companies in the United States are incorporated in Delaware. Besides, there is nothing wrong with trying to save taxes legally!
The Delaware flip
International companies entering the US market and planning to get US investors to expand significantly sometimes create a Delaware corporation and use what is called as “the Delaware flip”. This process requires all of the shareholders who hold equity in the foreign company to exchange their shares with the newly-formed Delaware corporation, in order to receive proportionate equity/shares in the newly-formed Delaware corporation. When this happens, the foreign company essentially becomes a wholly-owned subsidiary of the Delaware corporation, as it now has a single owner, the Delaware corporation. The shareholders instead own the Delaware corporation.
This makes it easier to attract US investors, in particular venture capital firms, who will be much more comfortable investing in a Delaware corporation than in a foreign company. It will also facilitate the process of going public if the company decides to raise funds through the stock market, which may be one of the main reasons for some international companies to set up a local presence in the US.
In addition, becoming a US corporation rather than the US subsidiary of a foreign company will have an impact on the perception of the company by clients and other stakeholders. In any case, there are many tax, legal and managerial implications derived from this step, so it would need to be analyzed carefully with support from experts to fully understand the consequences before moving ahead.
Conclusion
In conclusion, as a general rule, unless the company is planning to get external funding from investors at some point, it is usually not worth incorporating or forming the legal entity in Delaware. If external investments are expected, then it may be advisable to create the company in Delaware since it will facilitate getting the trust from investors. In that case, it will be a good idea to set up a “C corporation” (better than an LLC, which is the other option for international companies) because it is more difficult to sell or transfer membership or ownership in an LLC and fairly easy to trade shares in a corporation.
For small businesses or fully-owned subsidiaries of international companies who do not plan to raise funds from external investors, the added cost and complexity of setting up the business in Delaware and registering it in the state where it operates will normally not be justified.
Markentry USA can help international companies to define the best strategy to enter the US market and navigate all the key decisions, including where and how to set up their US subsidiary, when applicable.