Should I incorporate my new business entity in Delaware?

Should I incorporate my new business entity in Delaware?

So many owners of small or mid-sized businesses ask us about the benefits of incorporating their entities (corporation or LLC) in Delaware. There is clearly an assumption in the business community that there has to be some benefit to Delaware registration. Why else would most of the Fortune 500 companies do the same? Our usual response is that for most small and medium-sized businesses headquartered outside of Delaware, it makes little economic or legal sense to incorporate in Delaware, notwithstanding the mystique surrounding a Delaware incorporation.

Why are some of the largest companies in the U.S. incorporated in Delaware? Delaware has a long history of welcoming corporations. It was one of the first states to pass legislation governing corporations, including modern corporate registration statutes. This legislation has largely been tracked by other states. Delaware was one of the first states to pass management protection laws favorable to corporate decision makers. Delaware has a separate Court of Chancery with experienced, business-oriented judges that only hear cases involving business disputes and corporate governance. As a result, Delaware has a very rich history of case law decisions on corporate matters, and most other state courts have followed Delaware’s lead in this area of law. In addition, most venture capitalists and investors prefer that their targets be incorporated in Delaware, regardless of where they are actually headquartered, so that the Delaware courts have jurisdiction over future disputes.

In our view, for most small and mid-size companies, incorporating in Delaware is an unnecessary expense. For most companies, there is no tax benefit to doing so because corporate income tax is paid in the state where the income is generated, not where the company is incorporated. In addition, by incorporating the entity in Delaware, you subject the entity to being sued in Delaware, which may not be a convenient forum for you. Furthermore, since an entity is generally required to register in any state where it has offices or conducts substantial business (and appoint a registered agent in each such state), incorporating in Delaware means paying initial registration fees, on-going yearly fees, and registered agent fees in multiple states, which can be a substantial expense.

A number of years ago, our firm represented a local corporation that had incorporated in Delaware for no particular reason. Several years later, the owner discovered the registration in Delaware had lapsed, and the corporation owed tens of thousands of dollars in unpaid annual franchise taxes to the state. We were able to somewhat lower the total bill through an appeal with the Delaware Division of Corporations, but ultimately the corporation had to pay a significant portion of the back taxes in order to maintain the entity and its valuable contracts. Following payment, we quickly domesticated the corporation in Virginia where it was actually operating.

There are many online services that seek to incorporate your entity in Delaware for a fee. Some of those fees can go be as high as $3,000 or more. Consult with your legal counsel before taking the plunge, or you may find that you have made a very costly mistake. Here are a few of the false claims made by some of these online companies:
(1) you can reduce your taxes because of the low corporate tax rate in Delaware,
(2) there is more privacy for your personal information in Delaware, and
(3) the prestige of a Delaware entity is worth the cost.

Many states, including Virginia, are also corporate friendly states like Delaware. If privacy is a paramount concern of yours, speak with an attorney about the various ways to keep ownership information private wherever you incorporate. If you are fortunate enough to own a business that others wish to acquire or invest in, your entity can quickly be domesticated in Delaware if required by the buyer/investor.

Purchasing a Business: Legal Due Diligence | Gross, Romanick, Dean & DeSimone, P.C.

Purchasing an existing business is a complicated process with several stages. The most important stage for the buyer is the “due diligence” study. A thorough due diligence study should reveal areas of concern and possible mismanagement by the seller. The study will assist the buyer to make an educated determination whether to proceed with the purchase. Regardless of the structure of the purchase transaction (asset sale or equity sale), it is imperative that the buyer conducts a comprehensive review of the business, both from a financial and legal perspective. Hiring an experienced attorney is critical for the legal review, and engagement of an experienced CPA is critical for the financial review. Based upon the findings of the due diligence study, the attorney will make recommendations to the buyer and will attempt to structure the deal to protect the buyer’s best interests. Some issues commonly overlooked by buyers include:

1. Organization and Ownership of the Seller.

How is the selling entity organized? Who are the owners? Does the selling entity have any parent, subsidiary, or affiliated entities? If so, who are the owners of each? What agreements exist between the owners and the related entities? What ownership approvals are required for the sale to take place?

2. Registration, Permits and Licenses.

Where is the business registered? Is the business in good standing in all places where it is registered? Does the business need to be registered elsewhere? What permits and licenses are required to operate the business? Are the existing permits and licenses transferable?

3. Asset Review.

What assets are owned by the business? What assets does the business finance or lease? Where are the assets located? Are there recorded and/or unrecorded liens on the assets? Which assets are going to transfer in the deal? Which assets are not going to transfer? Are the assets transferable?

4. Contract Review and Leases.

What existing contracts is the business a party to? Does the business lease real property? Are the contracts and the leases transferable? What is the process for transferring the contracts and the lease(s)? Will the sale of the business result in a breach of any contract? What contractual obligations will the buyer be subject to following the sale?

5. Employee issues.

Who are the existing employees and independent contractors? Will they remain with the company after the sale? Are there existing employment contracts? Will the buyer want employees and independent contractors to execute new agreements? Is there an employee handbook? Are there employee benefit plans in place? Are there any disclosed or undisclosed employment disputes or potential violations of employment laws?

6. Lawsuits and Judgments.

Are there existing lawsuits against the business? Are there outstanding claims against the business or its owners? Are there existing judgments against the business that have not been satisfied and released? Are there potential lawsuits or administrative claims?

7. Taxes.

What types of taxes is the business responsible for? Have all prior taxes been paid? Are there any outstanding tax liens or assessments? Have all employee taxes been properly paid? Is there some contingent liability such as employees being improperly classified as exempt or non-exempt?

8. Creditor Issues.

Who are the creditors of the business? How much debt exists? Is the debt going to be assumed? Are creditors going to be paid out of the purchase price?

9. Other Issues

Insurance coverage; Franchise considerations; Environmental concerns; Customer relations; Intellectual property matters; etc.

The information learned from a thorough due diligence study will be critical to the buyer’s decision of whether or not to go forward with the purchase. In some cases, the anticipated structure of the deal will change based on the information that the buyer discovers, as the purchase agreement must be designed to protect the buyer from expected and unexpected legal problems following the sale.

Some ambitious (and imprudent) business purchasers believe that hiring an attorney or accountant to conduct legal due diligence will only “throw cold water” on the deal that the parties want to consummate. However, some of the most commonly litigated issues that arise following a business sale (including fraud and breach of contract) can often be eliminated by having an attorney and an accountant complete a legal and financial due diligence review prior to the closing of the deal.