One of the most common questions attorneys receive from entrepreneurs seeking to start a new venture is if it makes sense to form their business in Delaware.
Entrepreneurs are often well aware that investors look favorably upon Delaware entities and that a majority of Fortune 500 companies have selected the state as their place of incorporation. However, as with many legal questions, the answer as to whether or not forming an entity in Delaware will provide advantages to a new company is: It depends.
Delaware has long been at the forefront of corporate law and has developed a strong reputation as a business-friendly state. There are truly many incentives for entities to incorporate in Delaware.
Perhaps the two most notable reasons to incorporate in Delaware are the absence of certain state taxes and Delaware’s advanced corporate law. Delaware has no sales tax or state corporate income tax on goods and services provided by Delaware corporations on operations occurring outside of Delaware. Delaware’s corporate law is well regarded as the most advanced in the United States, providing more certainty for businesses. Additionally, the Delaware Court of Chancery only conducts bench trials, meaning companies can avoid the uncertainty that accompanies a jury trial.
However, for many small businesses there are drawbacks to forming in Delaware. Most notable among the drawbacks are the additional unnecessary costs and fees an entity with its operations based in Michigan will incur if it chooses to form in Delaware.
For example, Delaware limited liabilities companies are required to pay an annual fee of $300 per year and Delaware corporations pay an annual report fee of $50 plus an annual franchise tax. In addition to Delaware’s fees, if a company is planning to conduct business activities solely or primarily in Michigan, it will need to become authorized to conduct business in the state and will have to file an annual statement, just like a domestic Michigan entity, and pay the associated $25 fee annually. Further, a business will need to maintain a registered agent in both states. If the business lacks a physical presence in Delaware, it will need to pay a registered agent service located within the state. If a business does not gain a clear advantage from forming in Delaware, incurring the additional fees is unnecessary.
There are costs in addition to filing fees that are increased by forming a Delaware entity as well. For example, for companies that are obligated by federal or state law to file certain reports, the reports may need to be filed in both Delaware and Michigan. Beyond that, for a company whose operations are based in Michigan, the costs of defending litigation in Delaware may be unnecessarily burdensome.
Michigan, like many states, has adopted many, but not all, of the more favorable provisions of law found within Delaware’s Limited Liability Company Act and General Corporation Law. Thus, Michigan law allows for much of the same flexibility in management and many of the same opportunities to limit liability for members, managers and directors that Delaware law does.
For entrepreneurs who are involved in speculative ventures or side businesses, many of the same privacy protections which exist in Delaware are available in Michigan, especially in the context of limited liability companies.
Some entrepreneurs counter that they expect they may seek financing from venture capitalists at some point in the future and are well aware of how favorably Delaware is viewed by such investors, especially because of favorable taxes for investors. Such entrepreneurs should be aware there are solutions to this issue at the time venture capital will be invested, including forming a holding company for the investment or merging or converting the existing entity into a Delaware entity.
Ultimately, unless there is a strong business reason for a Michigan-based company to form in Delaware, most entrepreneurs in the initial stages of forming their business are best served forming their entity in Michigan.