By Jeffrey M. Sulenski
Pahl & McCay
225 West Santa Clara Street
San Jose, California 95113
408/286-5100 (phone); 408/286-5722 (fax)
Please understand that the information discussed in this Article is general in nature and is not intended to be legal advice. It is intended to assist owners and managers in understanding this issue area, but it may not apply to the specific fact circumstances or business situations of all owners and managers. You may need to consult applicable state and local laws. For specific legal advice, consult your attorney.
Business people in California are always looking for ways to get out from the tax thumb of California. One of the common beliefs among California business people is that incorporating their businesses in Nevada will save them a ton of taxes. Unfortunately, incorporating a California business in Nevada, or Delaware or any other jurisdiction, more often than not will not save any taxes. In fact, it will more likely cost the business more when factoring in the cost of having to comply with corporation requirements in two states.
One often misunderstood concept is that a Nevada corporation does not have to pay income taxes in California. In fact, California assesses income tax on entities with net income derived from sources within California, whether or not the entity is incorporated in, or qualified to do business in California. Another misunderstood concept is that foreign corporations (i.e., corporations formed in jurisdictions other than California) do not come within the corporate regulatory scheme in the State of California.
It is true that Nevada does not have an income tax and that a Nevada business does not pay state income tax. The problem is that California businesses usually conduct little or no business in Nevada. California business people usually have businesses operating in California, and if a business operates in California it likely will have to qualify to do business in California and pay at least the minimum franchise tax in California even though it may be a Nevada corporation. The critical issue is not the jurisdiction in which a business is organized, but the jurisdiction in which the entity is conducting its business. As a general rule, if a Nevada corporation is entering into transactions with Californians and earning income from those transactions, then that corporation is viewed as doing business in California. By doing business in California, the Nevada corporation would have to register in California as a foreign corporation doing business in California, and it will probably have to pay California tax on its income earned in California.
Under California law, a foreign entity, i.e., an entity that is not organized under California law, must qualify to do business in California if it is engaged in “intrastate” business in California. A business is engaged in intrastate business in California if it engages in repeated and successive transactions in California other than in interstate or foreign commerce. This definition is about as circular as you can get and has generated its share of case law. Essentially, it is a smell test – if looks like the foreign corporation is doing local business in California, it has to qualify to do business in California. If it looks like an out-of-state business that is merely selling goods into California, it is engaged in interstate commerce and does not need to qualify to do business in California. Most likely, the California business person who is incorporating a business in Nevada to avoid California taxes is going to be transacting intrastate business in California.
Foreign corporations that are qualified to do business in California must pay the minimum California franchise tax of $800 per year, and pay California income tax on their California income. A California business that incorporates in Nevada, then, will still have to pay California taxes. In addition it will have increased its compliance costs.
As a Nevada corporation, it will have will have to file its annual reports in Nevada and maintain an agent for service in Nevada (usually paying a fee to a commercial service to act as its agent in that state). As a Nevada corporation that is qualified to do business in California, it will also have to file annual statements of information in California and file tax returns and pay taxes in California.
Failing to qualify to do business in California can have dire consequences. Foreign corporations and their agents that conduct unauthorized business in California (i.e., failed to qualify to do business in California) are subject to penalties and fines. Such corporations are not allowed to maintain an action or proceeding in a California state court on any intrastate business conducted in California, which means they cannot file actions to collect their receivables in California courts. Finally, the contracts of corporations that have not qualified to do business are voidable at the option of the other party.
So why do California businesses incorporate in Nevada? Some are convinced to do so by one of Nevada’s many service companies who specialize in setting up Nevada entities for out-of-state businesses. These companies are truly full-service businesses that will provide everything an entity needs to appear to be located in Nevada, including an address, a physical office and a telephone number. The address is usually the office suite for the service company, the office is more of a time-share office on which the nameplate on the door is changed as needed to show that whatever business of the moment has real office in Nevada, and the telephone number is one of many being answered by the service company staff, who take messages and pass them on to customers, wherever they are located. These service companies make it extremely easy for someone to have a Nevada corporation with a presence in Nevada, all the while stressing that there is no income tax in Nevada. These service companies do not, however, clearly counsel their customers on the need for these Nevada entities to qualify to do business and pay taxes in the other jurisdictions like California if they are conducting intrastate business in those states.
One good reason for organizing in another jurisdiction like Delaware is to take advantage of the differences between California law and the law of the other jurisdiction. For instance, most public companies are organized under Delaware law because Delaware’s corporate law is “management-friendly” and the State of Delaware has a highly sophisticated and efficient court system for dealing with corporate law disputes.
Similarly, many lenders, especially for the larger conduit loans, require borrowers to own their real property using a Delaware limited liability company because Delaware law has provisions that are not available under California law but that lenders want to have in place to assure that the title-holding entity is bankruptcy remote.
It may also be advisable to organize an entity in another jurisdiction if a business is located in that jurisdiction. For instance, if commercial real estate is owned in another state, it may be best to create a title holding entity in that state to hold that property rather than to create a California corporation to hold that property.
Before setting up any entity it is important to consider whether there are good reasons for incorporating in Nevada or in any other state, but as a general rule, California business people with businesses operating in California will likely not benefit from forming a Nevada corporation.