Starting a Benefit Corporation? Should You Incorporate in Delaware?

By Sarah Kaplan

Benefit Corporation statutes have been spreading across the country, and on July 17, 2013, Delaware became the 19th state (plus D.C.) to enact this legislation.  This is great news for the benefit corporation movement because Delaware is the state for corporations. But does this mean that do-gooder entrepreneurs should all incorporate in Delaware?

Let's first ask: Why incorporate in Delaware in the first place?

For hundreds of years, Delaware's government--its court system, legislature, and administration--has focused on making things work for corporations. Delaware's General Corporation Law is updated regularly based on recommendations from the lawyers who serve the many Delaware corporations. The DE Secretary of State's Office runs efficiently and is user-friendly. But maybe most important is that Delaware's special court for corporate matters (the Court of Chancery) decides many cases and issues written decisions, and the result is a well-developed "body of law." That is, if you can think of a conflict that might come up, legal counsel can find out who got sued for what, who won, and why, in Delaware case law. This allows the corporation to plan ahead to avoid litigation. (In other states, there may be no clear answer, so avoiding a problem could be impossible.)

These effects snowball. Delaware has become known as the place to incorporate, so more companies do incorporate there, and the result is a huge number of corporations under Delaware law, with more and more all the time. This leads to more cases, which makes Delaware's case law even more detailed. Delaware law is known by corporate lawyers across the country, and the more companies go to Delaware, the more lawyers must get to know Delaware law. Delaware has become a common denominator, and part of the value is just its reputation. An investor might be more comfortable investing in a business that's incorporated in Delaware, even if the business's home state's law would work just fine. (For a more detailed discussion, see this article.)

Another reason is tax. In some situations, setting up a Delaware company or subsidiary can reduce a company's state tax bill. This depends on the type of income and in what state the income is earned. If your company makes income from intangible assets like intellectual property, your company may be able to benefit, but you'll need to see whether your home state's law will allow you to take advantage.

But would your business actually benefit by incorporating in Delaware?

There are some reasons to incorporate in the state where you're doing business.

1. Filing fees. There's a fee to form a new corporation or an LLC. You can form your new legal entity in any state, but you can't just start doing business in a state where you haven't filed. If you incorporate in another state (like Delaware), you'll also need to register with your home state's secretary of state as a "foreign" entity. For example, to do business in Illinois, you file an "Application for Authority to Transact Business in Illinois." The fee for that filing is generally the same as the fee to form a corporation.

2. Franchise tax and administrative work. You'll have to file an annual report and pay a franchise tax in the state where you're incorporated and the state(s) where you do business. If you're incorporated in one state and mainly do business in another state, you'll have to do the annual report and pay the franchise tax in both states.

3. Securities law. Any time you sell someone the opportunity to invest in your business, where they put in money and expect a return (without doing any work themselves), that's a security. Securities are highly regulated--you still can't sell securities to the general public, and you'll generally have to file some forms with both federal and state governments.

If you're doing most of your business in one state, and you're incorporated in that state, and you want to raise capital from people who live in your home state, then you can take advantage of the intra-state exemption to federal securities law (15 U.S.C. s. 77c(a)(11)). That exemption says that if your offering is just to the residents of the state where you do business, then state law can handle it, and the federal government doesn't need to be involved. If you don't advertise publicly, you may just need to file a simple form with your secretary of state. But, if you're incorporated in another state, this exemption won't work.

4. Tax--probably neutral. In general, business income is taxed by the state where the income is earned, so in general, incorporating in Delaware would not help you avoid state income tax in the state where you actually operate. If you do business mainly in one state, and incorporate there, you just file the one state tax return and be done with it. (If your income is from intangible property, you may want to consult a tax professional about this. This paper discusses the Delaware tax haven for royalties and its effect on state revenues.)

As you can see, the reasons to incorporate in your home state are more relevant to smaller businesses. A small company, e.g. a new brewery, might have investors who know the business is locally based. The quality (prestige?) of the court system is probably not an important consideration because the company is not expecting to get sued any time soon. The brewery's home state's law might do a fine job answering a few questions to get set up. Avoiding extra administrative requirements makes it easier to get the real work done.

As a business gets bigger, the reasons to incorporate in Delaware grow. A venture capitalist investing millions might want a Delaware corporation. A big business can expect lawsuits, so a great court system and highly detailed case law for corporate matters makes a difference.  (By the way, Delaware companies can only keep some of their litigation in Delaware courts. They can still be sued in another state, for example, if a faulty product hurt someone in that other state). A big corporation does not care if it has to file several annual reports--it's worth it.

Conclusion: The new benefit corporation law in Delaware is a great step forward for the benefit corporation movement because companies from all over the country choose to incorporate in Delaware, and they can now do that and be a benefit corporation. But that doesn't mean you need to go running off to Delaware--incorporating in your home state probably makes more sense for a new small business.

[Image Credit: Jeffrey]

Sarah Kaplan is a business attorney focusing on green businesses, worker cooperatives, and capital fundraising.  You can find more legal insight for co-ops and green businesses on her blog.