Let’s buck convention and start this post with the tl;dr (“too long; didn’t read”) version: for the vast majority of new small businesses, the best state to form in is the state where you'll be primarily located and where you do the most business.
If that answers your question and you want to stop reading right now, we don’t blame you at all. Like all rules, there are some exceptions, and in the rest of this post we’ll go over some of those exceptions, geek out just a little over the legal ins-and-outs of company formation, touch on exactly what “foreign qualification” is, and go over the most important reason for the rule: it’ll probably save you money.
Sticking with us for the long-ish haul? Great! Here we go:
Let’s say you’ve decided to start a business. You know you need to create a legal entity, and you may even have decided what type of entity you want to form - like a corporation or a limited liability company (“LLC”).
But you still have a big choice ahead of you: in which state should you form your company? Unfortunately, there’s a lot of bad advice out there on the interwebs (who'd've imagined that??), and that bad info might lead you to choose a less-than-ideal state in which to form your company. Why does that matter? Because get it wrong, and you’ll spend too much money. And for any new business, that’s a bad thing.
Lucky for you, Startomatic’s Starter Law 101 series is back with a practical, readable post that will help you make the best possible decision about where to form your company.
First of all, let’s think about how you actually “form” a company. A company doesn't exist, legally speaking, until you file a specific document with the Secretary of State of the state in which you are creating the company.
In most states, the document you file is called “Articles of Incorporation” if you’re forming a corporation, and “Articles of Organization” if you’re forming an LLC. Different states - and other types of entities - may mean the document you file has a different name, but for simplicity, this type of official, filed document is often called a “charter”, so that’s what we’ll call it here.
Why do states make you file a charter in order to create a business? Ok, we’re not quite cynical enough to say it’s a straight up money making operation - although the states do collect fees both when a company is formed and every year after that - those recurring fees are usually called “annual report fees”. But the real reason is that it’s important for states to know what businesses are operating within their borders.
Clearly, states have a legitimate interest in regulating businesses, if for no other reason than knowing how to get in touch with someone in charge. If you read our earlier Starter Law 101 post on “How to Start a Company Without Losing All Your Favorite Stuff”, you already know that having a registered business entity also gives business owners the wonderful protection known as “limited liability”. So in a lot of ways, business registration is a win-win.
“Foreign Qualification” Does Not Mean Making the Peruvian Olympic Team
We’ve seen that states have a reason to regulate businesses that operate within their borders. So if your business operates in a particular state, you will likely be required to “qualify” your company to do business in that state.
The state your business is formed in considers your company to be a “domestic” company, and by virtue of having formed there, you are able to do business in that state.
But what if your business operates in more than one state?
Let’s look at a tasty example: Say you form a Tennessee LLC in order to open a sweet, sweet BBQ joint in Memphis. Your LLC would be considered a “domestic” LLC in Tennessee.
Your ribs and spicy sauce get so popular you decide to open a second location over in Little Rock, across the border in Arkansas. With your home-spun dining room, dozen or so employees, and hardwood-burning smoke shack, you are definitely doing enough business in Arkansas to be required to qualify to do business there.
The question of whether or not a company is actually doing business in a particular state - and therefore required to register there - is a tricky one, and beyond the scope of this post - but don’t worry, we’ll address it in a later post!
Arkansas considers your Tennessee LLC to be a “foreign” business entity. You file to qualify your LLC to do business in Arkansas, and of course you pay a filing fee. You’ll also have to pay annual report fees in Arkansas.
Key takeaway: for each state in which you register your business, you’ll pay an initial filing fee (generally a few hundred dollars) AND annual registration fees (also a few hundred dollars). So you can see why it makes sense NOT to register your business in any state in which you’re not required to do so.
I Heard I Should Form My Company in Delaware (or Wyoming, or Nevada, or…)
Both Delaware and Nevada have made a push to encourage companies to incorporate there. Why? Well, we’ve admitted we’re cynical - but this is almost certainly a revenue grab. More registered companies = more fees for the state.
But for the vast majority of businesses, unless you’ve got physical operations in Delaware (or Nevada, etc.), there is no benefit to forming in Delaware (or Nevada…). You’d just have to qualify to do business in the states in which you actually ARE doing business - and that means paying extra fees every year, year after year.
There is one key exception to this advice. Companies that intend to take outside investment from professional investors (think venture capital funds or professional angel investors) will often form as Delaware corporations and just absorb the “extra” costs of foreign qualification in the state(s) in which they’re actually operating. This is because professional investors will often prefer or require that the companies in which they invest be formed in Delaware.
The bottom line: if you’re a new small business and don’t intend to take money from professional investors, you should form your company in the state where you’ll be doing most of your business on day one.
Our lawyers made us put this here: This Starter Post is for informational purposes only. It is not intended to provide any legal or tax advice.
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