When it comes to starting an LLC, there are a lot of factors to consider. But there is a common question. Which state is the best?
Some people say that Delaware is the best state because of its favorable business laws. Others say that California is the best place to set up shop, thanks to its large population and thriving economy.
However, there are several things to consider when deciding on the best state for your LLC. While there’s no one-size-fits-all answer, there are some factors you’ll want to consider when making your decision.
In this article, we’ll take a look at the pros and cons of forming an LLC in various states so you can make an informed decision about where to set up shop.
What Is A Limited Liability Company (LLC)?
Before we go further, defining what a Limited Liability Company is may be helpful.
At its core, a Limited Liability Company (LLC) is a business entity that provides personal liability protection for its owners. LLCs are popular among entrepreneurs because they offer the personal asset protection of a corporation with the ease of management that a sole proprietorship or general partnership provides.
They also provide the most tax flexibility of any other entity. This tax flexibility allows the business owner to take advantage of the best tax strategy as the business grows.
Related: What benefits do LLCs provide?
Domestic LLC vs Foreign LLC
Before continuing, there are a couple of terms to be aware of, which are a Foreign LLC and a Domestic LLC.
A Domestic LLC is an LLC that is formed in the state where it will be doing business. So, if you are an Illinoisan and want to form an LLC to do business in Illinois, you would simply file the paperwork (Articles of Organization) with the Illinois Secretary of State to form a domestic Illinois LLC.
A Foreign LLC is not one that is formed in another country but one that was first formed as a Domestic LLC in another state (commonly the headquarters or home base) and wants to do business in another state physically. The definition of what qualifies as doing business will vary slightly between states, but common reasons to file as a Foreign LLC in another state include opening an additional retail location, building a warehouse, or hiring an employee.
Read more: What’s the difference between a Domestic LLC and a Foreign LLC?
Should You Start An LLC In A State Other Than Your Home State?
As with most things legal, if you are thinking of forming an LLC outside of the state you reside in, we recommend consulting with an attorney and accountant, as not everything you read on the internet is right. Not only that, but regulations vary by state, and even if something is technically correct, there are often nuances and personal factors to take into account that may change the answer for you.
We are not providing legal or accounting advice, but we will share with you what we have learned after working with many startups.
It’s generally best to form an LLC where you reside and will be doing the work.
This statement is still true for businesses that don’t have a physical location, such as businesses that solely operate over the internet, drop shipping, etc.
Common Reasons to Start An LLC in Another State
Even though we say it’s generally best to open an LLC in the state where the owner resides, you would like to know why.
Here are two of the most common reasons someone would want to open an LLC outside of their home state.
Taxes
Let’s say you are a small business owner who lives in a high personal income tax state like New Jersey and wants to form an LLC in a state without no state income tax like Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. Sounds great in theory, right? Well, unfortunately, unless you are physically working in a state with no personal income taxes, you will still have to pay income tax in New Jersey on the profits of the LLC in most cases.
There’s an old saying by accountants that goes, “The taxes are paid where the money is made,” and it will probably apply to your business. Even if your business is officially registered in another state, but the work is being done somewhere else, the revenue will in most cases be taxed where the work is taking place due to what’s called “economic nexus”.
Economic nexus refers to where a business has a physical presence. For example, if you are doing work from New Jersey, whether you ring up sales in a retail storefront, pack orders in a warehouse, or take orders over the internet in your basement, you have what’s called “economic nexus” where the income was generated.
So, let’s say our high-tax New Jersey business owner decides to open an LLC in low-tax South Dakota. Our New Jersey business owner operates an online business and inventory is fulfilled in Amazon Warehouses. Due to economic nexus, the New Jersey business owner is operating the business from New Jersey, and because of this, his income is considered as being earned in New York. So, he hasn’t been able to avoid income taxes at all.
Not only that, but our New Jersey business owner is also responsible for registering the South Dakota LLC and registering it as a Foreign LLC with the state. This isn’t a unique cost to New Jersey, but every state is similar. So, at the end of the year, a South Dakota and New Jersey annual report will be due.
To make matters worse, our business owner will probably need to pay for a South Dakota registered agent. A registered agent (referred to as a resident agent in some states) is someone who is physically present in the state during normal business hours to receive important correspondence from the state and notices of lawsuits. If this business owner doesn’t have someone who can act as the registered agent in South Dakota, they would have to hire someone to take their place.
While the original goal was to save money on taxes, the end result is a higher cost and more complexity due to the additional filing.
High fees
Some states charge a lot to have an LLC, and who wants to pay more than they need to? In California for instance, every LLC must pay an $800 franchise tax each year. But what if, instead of forming an LLC in California, you could save money by forming an LLC in a state like Wyoming, which has no franchise tax and low annual report fees? Unfortunately, under the California Franchise Tax Board, if you are “doing business” or organized in California, you are required to pay the annual franchise tax.
The definition of doing business can be broad, but the California Revenue and Taxation Code (R&TC) section 23101, states registration is required with the state of California when:
- Engaging in transactions with the purpose of making a profit in California
- A business is organized, or commercially domiciled in California
- Annual sales originated in California exceed $500,000
- Real estate or property assets in the country exceed $50,000 or 25 percent annually
- Compensation of over $50,000 is paid annually in California
Trying to make a profit and doing so while living in California makes you liable for paying the franchise tax. This holds true, even if you are a consultant and leaving the state to complete all of the work, you would be liable for the franchise tax, since you were in California when you took the phone call to work out the details.
Ok then, you may be saying, my LLC formation may be best to do in my state. But surely there are reasons I see all of these ads to form an LLC in a different state.
And, it’s true, there are some non-monetary reasons to consider, such as:
Privacy
In some cases, it might make sense to form the LLC in a state that doesn’t require public disclosure of who the owners of an LLC are. This can be beneficial for people who want to keep their ownership stake private for personal or security reasons.
LLCs that provide more privacy than “regular” LLCs have been branded as “anonymous LLCs.” An anonymous LLC isn’t a special type of LLC. It refers to a handful of states that don’t publically disclose the name and address of LLC owners.
There are four states that provide this protection, which include:
- Delaware
- Nevada
- New Mexico
- Wyoming
Related: What is an anonymous LLC?
Even though there are special states that do a better job of hiding the names of the LLC owners, another option is hiring a commercial registered agent service. This also works in many states to hide the names of the owners.
Asset Protection
Some states have stronger asset protections for an LLC than other states. This stronger protection comes from the rights of a creditor to collect in what’s called a charging order.
If an LLC is sued and loses in court while the owner’s personal assets are safe, the charging order allows a creditor to put a lien on the assets of the LLC. As you would guess, state laws vary, however, there are more business-friendly states that provide stronger charging order protections such as Arizona, Delaware, Nevada, and Wyoming, where the creditor can’t force the sale of the LLC to satisfy debts, while other states can force the LLC into liquidation.
