This is Part Four of four blogs discussing which American jurisdiction is the best to form a legal entity?). In these four blogs I discuss several factors that you might consider when you choose where to form a business (read Part One, Part Two, Part Three): 1) Situs of Business; (2) “Choice of law”; (3) Ease and cost of formation; (4) Privacy/confidentiality; (5) liability protection for members/shareholders; (6) Personal liabilities of members/shareholders and directors; (7) state taxation.

There are many other factors – which we do not discuss – that might be relevant when you choose where to incorporate: financial factors (e.g., such as cost of production, labor cost, etc.), condition of infrastructure, connectivity, business climate, relationship with other foreign investors, and possibly others.

Here we deal with factor no. 7, the tax factor. We discuss state taxation (as opposed to federal taxation). In fact, when you form an entity in the U.S., you should also consider federal taxation (which is the biggest part of your tax bill) – we do not discuss it here because federal taxation is the same in every jurisdiction, so that it is not an element relevant for the choice. International taxation considerations are also important for foreigners, but they are beyond the scope of this blog.

[Read factors (1) and (2) in Part One, factors (3) and (4) in Part Two, and factors (5) and (6) in Part Three]

7. State taxation – i.e. which is the best American State for formation of an entity under a tax perspective?

A deceptively easy answer to the question would be to form in the state where there is no corporate and no personal income tax. Under this perspective South Dakota might be the best State where to form a business (at least according to Tax Foundation, a taxation think tank in Washington, DC). There is no corporate or personal income tax in South Dakota. South Dakota, however, might not be the right answer to the question if you are not actually doing business in South Dakota. The place where you actually perform your activity matters. The reason is nexus.

Nexus is the most important principle to consider when you talk about state tax, i.e. which is the minimum connection between a business and a State that allows that State to impose a tax.

Clear enough is the situation with sales tax because there are two Supreme Court decisions: Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977) and Quill Corp. v. North Dakota, 504 U.S. 298 (1992).

In Complete AutoTransit, an auto transporter (Complete Auto) transported General Motors cars from Jackson, Mississippi to several Mississippi dealerships. The Mississippi State Tax Commission levied a tax upon Complete Auto “for the privilege of engaging or continuing in business or doing business” in the State of Mississippi, qualifying it as a “sales tax” but actually it was a tax on Complete Auto’s gross receipts. The tax was equally applied to businesses involved in intra-and interstate commerce.   The Supreme Court had to decide if the tax was unconstitutional based on the Commerce Clause. A unanimous Court found the tax valid. The Court’s decision established a four-prong test for a state tax to be valid: The tax (1) must be on an activity connected to the State (substantial nexus), (2) fairly apportioned based on intrastate commerce, (3) nondiscriminatory, and (4) related to services provided by the State.

In Quill Corp. v. North Dakota, 504 U.S. 298 (1992), the Court defined what a minimum nexus is for sales tax purposes: for a State to collect sales taxes from a business, the latter must have more than a de minimis amount of business in that State. See here.

The Supreme Court, therefore, has spoken on nexus and sales tax, not on income tax or gross receipts taxes or franchise taxes.   We do not have precise constitutional criteria that States must follow to collect those taxes (nexus for income tax or franchise tax purpose), which results in states following different, perhaps even conflicting, criteria. This is a risk that we must consider when you decide where to form an entity.

Generally speaking, people and property create nexus with a state. The critical element is the so-called “economic nexus,” i.e. when an out-of-state business is deemed to have “nexus” with a state based on factors different from a physical presence. For example: a New York service provider has customers in California – does it have to file there? A dozen States have a bright-line-rule: if you derive a certain amount of revenue from in-state residents (which can be $350,000 as in Ohio and Michigan or $500,000 like in California and Colorado), then you are deemed to have an economic nexus with the state and you have filing responsibility in that state. See a list here. New York has recently become a bright-line-rule state: businesses that derive $1 million or more in New York receipts are deemed to have economic nexus with NY. See here.

The remaining states, however, do not have bright line rules and businesses lack guidance as to whether they are subject to taxation. To be sure: economic nexus with a state does not mean that you have to qualify to do business in that state even if you are required to file a return. (see Part One for qualification to do business). Indeed, the definition of “doing business” in a State is a state regulation while the taxation has some constitutional wrinkles (e.g., Quill Corp).

For completeness, consider that even a foreign provider can be considered to have nexus with a US jurisdiction; and this is true also when the US and the foreign country signed a treaty against the double taxation. Such treaties, while they give a break to foreigners on federal taxation, do not shield them from state taxation. See here.

What are the State tax factors to consider when choosing the jurisdiction in which to incorporate and do business?

(i) in which jurisdiction will you make business (i.e., so probably have nexus)?

(ii) are we talking about an existing business or new business?

(iii) can you locate your business anywhere or is the location of your business predetermined?

(iv) do you know from the formation time that in the future your business may move elsewhere?

(v) have you considered that because almost all jurisdictions deem “domestic” companies to have nexus regardless of their presence, you will be bound to file a “return” in the state of formation?

(vi) what type of “return” is required in the state of formation and what are the potential costs?

(vii) are there tax incentives for business in a certain jurisdiction?

To make an informed decision regarding the jurisdiction of formation you must consider two potential situations and consider what the several jurisdictions do in those two cases:

A) Requirements for businesses that are formed in a state regardless of whether they do business in the state;

B) Requirements for businesses that operate in the state of formation.

As we did in Part One, Part Two, Part Three, we can only discuss the situations in some of the jurisdictions; we discuss New York, Delaware, Nevada and Wyoming, as the most common places for formation of an entity.

A) Requirements for businesses that are formed in a state regardless of whether they do business in the state

We are discussing here what a domestic corporation pays independently from the fact that the activity is or is not performed here.

Nevada – Every domestic corporation must file an initial list of directors and officers on incorporation; update this list annually, and pay an annual fee ranging from $125 to $11,100 based on number of shares of stock authorized.

Wyoming – Every domestic corporation must file an annual report and pay a license tax based upon the sum of its capital, property, and assets reported of $50 or $.0002 per dollar value, whichever is greater.

 New York – All domestic corporations are subject to corporate tax regardless of whether they do any business, employ capital, own or lease property, maintain an office, or engage in any activity in the State.

Delaware – Imposes an annual stock-based franchise tax on domestic corporations. Tax ranges from $35 to $165,000 depending on authorized capital stock.

B) Requirements for businesses that operate in the state of formation.

Nevada – Does not impose a corporate income tax.

Wyoming – Does not impose a corporate income tax.

New York – Income tax (7.1%) on apportioned net income and 0.15% tax on capital. And NYC has an additional 8.85% tax on apportioned net income (more here)

Read here on business taxation in the State of New York.

Delaware – Income tax (8.7%) on apportioned net income.

We mentioned above the concept of “apportioned net income”. An explanation is needed. “Apportioned net income” means how much profit is subject to income tax in the several jurisdictions. Unfortunately the measure of apportionment varies. It depends on the apportionment formula. Some States today use a single factor sale, i.e. the jurisdiction bases its taxes only on the share of sales that happened in that jurisdiction. By contrast, a majority of jurisdictions use a “three factor formula” (property, payroll, and sales) that is more traditional and less beneficial for companies). . New York uses the “single factor” formula while Delaware used a “three factors, equal weight” formula. Nevada and Wyoming do not impose a corporate tax so that so apportionment formula is used.

In conclusion, a couple of general thoughts on revenue taxation in “our” four jurisdictions: if you incorporate in Nevada and you do business only here, you will have to pay no State income tax at all. So Nevada is a great place for a business that only operates in Nevada or a multi-state business, in which case the business will be taxed for a portion of profit (apportioned net income) in every State (and in some States it can be up to 15%). Wyoming is a: very good State if you do business there or you are a multi-State business. New York imposes corporate taxes on all domestic corporations regardless of whether they do any business here. Also, New York has high taxes and to those you have to add an extra 8.85% for New York City tax (if you operate in NYC). There are some interesting tax incentives in New York but all in all costs are high. Delaware is a good State to incorporate if you do not have a nexus with Delaware (no corporate tax if no nexus but attention: there is a franchise tax on shares, which can be expensive if you issue many shares). However, with the exception of companies managing intangibles, which are exempt from Delaware corporate tax – see 1902(b)(8)), Delaware is not a particularly good State to incorporate if you have nexus there because, while DE does not have a sale tax, Delaware has 8.7% income tax.

Tax credits, grants and loans: Tax credits and other benefits are a factor that should be considered when you think about the jurisdiction where to form your entity under a tax perspective. Because they vary from State to State and from moment to moment, we cannot discuss them here. We encourage interested entrepreneurs to reach out to the state agency for the promotion of business to learn the available incentives in the relevant State (here for example New York). Attention: you might also want to consider that occasionally some state programs (e.g., tax credits, grants) require a “home state” business.

Some additional thoughts for dot-com companies (e.g. ecommerce). You might wonder whether an Internet company has nexus in all 50 States if it serves customers everywhere. While in theory this is possible, we know from Quill Corp that the company will not have to pay sales tax in every State in which consumers are located but only in those States in which it has more than a de minimis presence. For other taxes, which are based on “economic nexus,” where not many States have a bright-line-rule (see above), the situation is uncertain. A small protection: for certain activities performed in jurisdictions different from the State of formation, a protection is afforded by the Interstate Income Act of 1959, which affords immunity from taxation to out-of-state businesses that solicit in that state to sell tangible personal property (but not for solicitation of other activities, such as leasing, renting, licensing or other disposition of tangible personal property, or transactions involving intangibles, such as franchises, patents, copyrights, trademarks, service marks and the like, or any other type of property). See 15 U.S. Code § 381 – Imposition of net income tax.

The Act applies to ecommerce. We note for completeness that the Act does not apply to service providers (e.g., law firms, architects, web designers). Those businesses will have to analyze whether their conduct in a jurisdiction amounts to “economic nexus”.

For more information, Francesca Giannoni-Crystal.