Three Questions to Ask Before Incorporating in Delaware

In the business world it was once commonly said that “no one ever was fired for buying IBM.” Given Delaware’s preeminent market share, the same thinking may underlie a recommendation to incorporate there. Before making that decision, I encourage you to consider the following three questions:

1. Does the corporation want to pay a lot more money in taxes?

Delaware imposes a franchise tax on corporations incorporated in that state. The tax has nothing to do with the offer and sale of franchises. Rather, it is a tax “for the use of the State, by way of license.” Del. Code tit. 8, § 501. There are two ways for determining the tax – the Authorized Shares method and the Assumed Par Value Method. The maximum tax per year under either method is $180,000. Del. Code tit. 8, § 503(c). If there isn’t careful planning, the tax can be enormous for small corporations. For example, assume that a corporation has 1,000,000 authorized shares of one class of stock, par value $.01 per share; 100,000 shares issued and outstanding; and $5,000,000 in gross assets. According to the Delaware Secretary of State’s franchise tax
2. calculator
, this corporation would owe $7,675 each and every year. This tax is owed regardless of whether the corporation actually has Delaware income.
3. 
   
4. 
   
In contrast, California’s Secretary of State imposes a fee of just $25 for filing annual statements. California also has a franchise tax, but unlike Delaware’s tax, it is a tax based on the corporation’s income. The minimum franchise tax is $800. Cal. Rev. & Tax. Code § 23153. Incorporating in Delaware will not avoid California Franchise Tax if the corporation will qualify to transact intrastate business or will be doing business in California. Thus, incorporating in Delaware will mean that the corporation will be subject to California and Delaware franchise taxes.
5. 
   

6. Do the corporation and its directors and officers want to litigate in Delaware?

Although the Delaware Court of Chancery enjoys a strong reputation for experience in resolving business disputes, Delaware is a long way from California. Delaware has enacted an “implied consent” statute, Del. Code tit. 10, § 3114. Under that statute, an officer or director is deemed to have impliedly consented to personal jurisdiction in Delaware by virtue of accepting and holding office, regardless of whether the officer or director has ever set foot in Delaware. For corporations whose management, shareholders and business are located in California, litigation in Delaware can be expensive and terribly inconvenient.
7. 
   

8. Will the rules really be different?

California has a long history of subjecting foreign corporations to many of the same requirements as California corporations. In some cases, these requirements even apply to corporations with outstanding securities listed on the New York and Nasdaq stock exchanges. Delaware lawyers may consider the application of California law to Delaware corporations to be a dead issue in light of the Delaware Supreme Court’s holding in
9. VantagePoint Venture Partners 1996 v. Examen, Inc.
, 871 A.2d 1108 (Del. 2005). However, the California courts may reach a different conclusion. In addition, there may be disputes about what constitutes a corporation’s “internal affairs.”