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The Enduring Appeal Of The Delaware Corporation

Global Incorporation Guide [GIG] Editorial

July 14, 2016

With Bermuda the latest jurisdiction to attempt to replicate Delaware's successful limited liability company format, this article looks at the US state's enduring popularity with investors worldwide, its tax environment, what other corporate forms are available in the state, and the requirements for forming a Delaware corporation.

Introduction to Delaware

By area, Delaware is the second smallest state in the US, with Rhode Island being the only territory that is smaller. Despite this, Delaware is the biggest state for the formation of business entities.

At the end of 2013, almost two-thirds (65 percent) of the Fortune 500 companies were incorporated in Delaware. That year, there were over 152,000 new business formations in the state, including 34,234 corporations, 109,169 LLCs, 8,234 limited partnerships or limited liability partnerships and 1,260 statutory trusts. This took the total number of active business entities in the state to over 1m – more than one company per Delawarean. Overall new entity formation in 2013 grew 5 percent.

Why Delaware?

Delaware is popular as a place to form a company because its legislation is very business-minded, and partly because the state's corporate income tax only applies to business conducted in Delaware itself. If a corporation does not conduct business in Delaware, the only tax paid to Delaware is an annual franchise tax.

Indeed, the legal environment in Delaware is very conducive to businesses with complex affairs. Courts in Delaware frequently handle significant cases on an expedited basis in which time is critical to the litigants. Delaware's Summary Proceedings Act offers a unique procedure to resolve major commercial disputes on an expedited schedule with special rules to minimize the burden and expense of litigation.

As long as the corporation maintains a registered agent in Delaware, and a Delaware corporation, limited liability company, or business entity can be formed without a visit to the state, corporate offices may be located anywhere in the world. Furthermore, Delaware corporations have no minimum capital requirement. The state also has a very quick process for the formation of entities, by accepting electronic filings and allowing the formation of international entities on weekends or US holidays.

As the Delaware Department of Corporations itself puts it: "More than one million business entities take advantage of Delaware's complete package of incorporation services, including modern and flexible corporate laws, our highly-respected Judiciary and legal community, a business-friendly government, and the customer-service-oriented staff of the Division of Corporations."

Nevertheless, while Delaware is undoubtedly one of the most popular corporate domiciles in the United States, it is by no means the most popular. Many small business entities prefer to form in the state where they expect do most of their business. Hence, the more populous states in the US have more registered companies than Delaware. What sets Delaware apart is its appeal to public corporations, multinational enterprises that engage in merger and acquisition activity, and complex alternative entities. And this is largely because its legal infrastructure is geared towards catering for these types of business.

Taxation In Delaware – An Overview

At state level, companies are only required to file a Delaware Corporate Income Tax Return if they conduct business in Delaware and, then, they are only taxed on income deriving from business conducted in Delaware. Companies are exempt if their activities are limited to managing and maintaining intangible investments, provided they submit an Application of Exemption. Delaware also has no taxes for pass-through income.

Companies incorporated under the laws of Delaware do not have to file a Delaware Corporate Income Tax Return if they do not conduct business in the state. Non-profit organizations are also exempt from filing a return, although they do have to submit an annual report with the Delaware Division of Corporations.

Regardless of exemptions for the Delaware Corporate Income Tax Return, all corporations formed in the United States are taxed on worldwide income at the federal level. S corporations do not pay federal income taxes but, instead, see their shareholders taxed for their portions of the corporation's income or losses.

Income deriving from business conducted in Delaware is taxed at a rate of 8.7 percent and the state has no provision for a minimum corporate income tax. In addition to this, all companies must pay a Franchise Tax, regardless of where they conduct business.

Franchise Tax varies with different corporate entities. C corporations and S corporations pay a tax according to number of shares or assumed no-par capital. This cost varies between USD175 and USD300 for most, although larger corporations sometimes have additional fees depending on their size. LLCs, limited partnerships, and general partnerships face an annual Franchise Tax of USD300.

Delaware – A Secretive "Onshore" Tax Haven?

Unsurprisingly, the Delaware authorities are keen to repudiate what they see as certain "myths" about the state, spun both domestically and internationally. These primarily center on accusations that Delaware enables company owners to hide behind an immovable corporate veil and pay no tax.

On the first point, that of anonymity, the Delaware authorities argue that the state is no different to most other US states, in that the recording and publication of beneficial corporate ownership information is generally not required when a company is formed. It points out that information regarding business owners, partners, officers, and other responsible persons is, however, collected through tax authorities such as the US Internal Revenue Service and, where a company engages in business inside the state, by the Delaware Division of Revenue.

On the other hand, Delaware, along with many other states, does require its corporations to disclose the names of the natural persons who serve as directors, as well as reveal the names and addresses of its directors on its annual franchise tax report. All such filings with the Delaware Division of Corporations are public records.

The Division of Corporations also says that a number of steps have been taken in recent years to increase transparency. For example, in 2002, Delaware became the first US state to ban the use of bearer shares. Then, in 2006, Delaware became the first state to introduce a Commercial Registered Agent law, which provides a limited regulatory framework for company formation agents and enables the state to tackle fraudulent practices. Furthermore, in 2012, Delaware's Secretary of State adopted listing standards that cracked down on company formation agents that marketed shell and shelf companies.

The Department says that one of the most important legal mechanisms allows managers, investors, and law enforcement to inspect the books and records of Delaware business entities, and such inspections are said to occur on a regular basis.

"In short, Delaware is not a secrecy haven, any more than any other state or the United States itself. Indeed, Delaware has done more than most states to ensure proper transparency," the Department states.

With regards to the second "myth," that Delaware is a tax haven, the Government insists that such comparisons are "inaccurate." Just because a company is registered in Delaware doesn't mean that it is excused from fulfilling all its federal tax obligations. What's more, as also mentioned above, in general, Delaware taxes income deriving from business conducted in the state. Indeed, the state claims that alongside personal income tax, the franchise tax is its biggest source of revenue.

The state also refutes the idea that it provides companies with numerous loopholes to help them avoid tax. Most states provide businesses with an array of exemptions, tax credits, deductions and other incentives to conduct certain operations within their borders, it notes. Delaware is not much different insofar as it provides an exemption from state corporate tax for certain Delaware holding companies, namely corporations that derive 100 percent of their income from passive economic activity, such as licensing of intangible assets. However, the Department of Companies says that of the more than 1m legal entities in Delaware, only 1 percent are classed as holding companies.

Indeed, Delaware acknowledges that while it imposes a moderate tax burden on companies in the state, there are plenty of other states with a lower tax burden. In essence therefore, Delaware's tax system is not much different to those in place in the other 49 states.

Corporate Forms In Delaware

The following sections look at a sample of the different company forms that are available in the state of Delaware, starting with the ever-popular Limited Liability Company.

Delaware Limited Liability Company (LLC)

Formed by filing a certificate of formation with the Delaware Secretary of State, a limited liability company is a separate legal entity having the power to conduct business, acquire, hold and dispose of property, and sue or be sued in its own name. A limited liability company may only have one member. Management may be by the members or by selected managers who may or may not be members themselves.

As with limited partnerships, the relationships among members and the management structure are typically set forth in a written limited liability company agreement. Such an agreement may provide for various classes of members and managers and their respective rights, powers and duties. It may also set forth the manner of allocation of profits and losses of a limited liability company to its members.

Principal attributes of a limited liability company include:

  • any member or manager may bind a limited liability company;
  • except in certain limited situations, no member or manager is personally liable for the debts or obligations of a limited liability company;
  • Perpetual existence.

Delaware Limited Partnership

Delaware limited partnerships must consist of at least two people, with a minimum of one general partner and one limited partner being required.

Limited partners are passive members in a limited partnership, sharing profits (or losses) but not participating in management decisions, leaving a general partner to oversee the daily activities of the partnership. If a limited partner takes an active role in the daily running the partnership, a court may treat them as though they are a general partner.

Any limited partner assets are protected as they are kept separate from the liabilities of the partnership, while those of a general partner are not protected unless the general partner is a corporation or LLC. If the general partner is a separate entity (as is often the case), additional costs and tax consequences come into play.

The aspect of personal liability in a limited partnership tends to encourage more people to opt for a LLC. More than two-thirds of new business entities in Delaware are limited liability companies, while fewer than 10 percent choose limited partnerships. Advantages in favour of limited partnerships include them being easier for investors to understand, and better pass-through tax treatment for foreign equity holders.

Delaware Limited Liability Partnership (LLP)

Delaware authorizes a special form of general partnership known as a limited liability partnership. In a limited liability partnership, the partnership is required to register with the Delaware Secretary of State and maintain a specified amount of liability insurance. In return, partners are relieved of personal liability for obligations of the partnership. Partners remain personally liable for their own negligence or misconduct and that of persons under their direct supervision and control.

The limited liability partnership is attractive to professionals who want the benefits of the partnership form but without the personal liability for the professional misconduct of other partners and their employees.

Historically, the disadvantage of limited liability was that limited partners could have no participation in partnership management, which was vested entirely in the general partner. However, Delaware's limited partnership laws provide a great deal of flexibility in this area. It is possible to structure a limited partnership agreement that gives considerable management participation to limited partners without jeopardizing their limited liability.

Without loss of limited liability, limited partners may:

  • Conduct business with the limited partnership;
  • Be a control person of a general partner;
  • Consult with and advise the general partner;
  • Serve on a committee of limited partners;
  • Vote on matters such as dissolution, a sale of assets, a merger, and admission or removal of a general partner.

Limited Liability Limited Partnership (LLLP)

The limited liability limited partnership is a new form of entity which offers further liability protection for limited partners. The LLLP shields limited partners who have taken active control in the partnership and who may otherwise gain liability as general partners.

Delaware Business Trust

A Delaware business trust, another extremely flexible business structure, is an unincorporated association created by a trust instrument and the filing of a certificate of trust with the Secretary of State of Delaware. A governing instrument, which includes the trust instrument, provides for the governance of the business trust and the conduct of its business. A governing instrument may provide for various classes of trustees and beneficial owners and define their respective rights, powers, and duties.

A business trust has perpetual existence. It is managed by one or more named trustees who are not liable for the obligations of the business trust. The beneficial owners have the same insulation from liability as shareholders of a corporation, have an undivided beneficial interest in the business trust's property and have no interest in specific business trust property. However, the governing instrument may alter any of these attributes. In most cases, at least one trustee must be either a Delaware resident or have a principal place of business in Delaware.

Forming A Delaware Corporation

Delaware law requires that every business entity have and maintain a Registered Agent in the State of Delaware who may be either an individual resident or business entity that is authorized to do business in the State of Delaware. The registered agent must have a physical street address in Delaware. If the business is physically located in Delaware, then the business may act as its own registered agent.

The Delaware Division of Corporations allows for the reservation of an entity name, although this is not a requirement. However, reserving a name will guarantee that the name is held for the applicant for a period of 120 days. There is a fee of USD75 for the name reservation service.

Certificate of incorporation/formation forms can be completed in PDF format and can be mailed or faxed to the Department of Corporations. A cover sheet with the applicant's name or entity name, return address and phone number is required. All filing fees must be paid upon submission of the application.

Some financial institutions require a certificate of good standing or a certified copy of a new entity filing before they agree to open a business account. Such certification can be ordered at the same time as the new entity request. The fee is USD50 per certificate for a Short Form Certificate of Status (states name and status of entity) or USD175 for a Long Form Certificate of Status (states status and all documents ever filed on entity). Additional fees are payable if the application is being processed under the expedited service.

All corporations incorporated in the State of Delaware are required to file an Annual Report and to pay a franchise tax (see above). Exempt domestic corporations do not pay a tax but must file an Annual Report. The Annual Report filing fee for all other domestic corporations is USD50 plus taxes due upon filing of the Annual Report. Taxes and Annual Reports are to be received no later than March 1 of each year.

Sole proprietorships do not file with the Delaware Division of Corporations. Unincorporated nonprofit associations and partnerships have the option of making certain filings with the Delaware Division of Corporations.

 

Tags: law | business | tax | Tax | United States | fees | Bermuda | environment | interest | company formation | professionals | legislation | court | trusts | investment | insurance | small business | licensing | proprietors | tax credits | standards

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