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3. ENTITY FORMATION

c. Location

Once you decide to create a new entity, the next step is to decide where to organize the entity. The “common law” legal system of the United States does not require an entity to organize in the same location as its primary place of business. Instead, the entity may organize in any state or foreign country. Usually, fund management companies are organized in their home state or Delaware, and private equity funds are organized in Delaware or an offshore location.

When deciding where to organize your entity, consider the following legal, financial, and marketing issues.

Legal Issues

From a legal perspective, the internal affairs of an entity are usually governed by the laws of the place of organization. “Internal affairs” are the relations among the owners and managers of the entity. Relations with employees are typically governed by the laws of the place of employment, not the place of organization.

Even though the choice of location is virtually unlimited, the most popular options for California-based entities are California, Delaware, and Nevada. California is the obvious choice, but Delaware and Nevada offer various advantages over California. However, California law may reduce or eliminate those advantages by granting certain rights to owners that are California residents.

Delaware has a relatively well-developed legal system for business matters. The laws are comprehensive yet flexible, with a strong policy in favor of freedom of contract. This gives the founders more leeway to create their own rules. Also, Delaware has extensive case law regarding business disputes, which benefits companies by providing more certainty to the applicable law. In addition, conventional wisdom dictates that Delaware tends to favor companies over creditors, and fund managers over investors.

The legal system of Nevada is less developed than Delaware. However, the statutes and courts of Nevada share the reputation of Delaware as friendly to business.

California has a reputation as being less friendly to business. In any case, the business laws of California may, to a certain extent, also apply to entities organized elsewhere. For example, Section 2115 of the California Corporations Code imposes an extensive list of requirements on out-of-state corporations meeting the threshold amounts of property, payroll, sales, and shareholders within the state. As another example, if a non-California LLC has California members that possess at least 25% of the voting interests, then Section 17453 of the California Corporations Code grants the California members the same information and inspection rights that apply to California LLC's.

Financial Issues

From a financial perspective, you should consider the expenses of each jurisdiction. This section discusses franchise taxes, income taxes, service agent fees, and employment taxes and costs. Additional expenses may apply. For more information, consult with a tax attorney or accountant.

California imposes the following franchise and income taxes on entities organized or registered in the state:

Type of Entity	State Franchise Tax (annual)	State Income Tax (annual)
C corporation	$800 starting in second year in California, or $0 if state income tax exceeds $800	8.84%* of California net income, if the state income tax exceeds $800
S corporation	$800 starting in second year in California, or $0 if the state income tax exceeds $800	1.5%* of California net income, if the state income tax exceeds $800
LLC (if taxed as partnership or disregarded entity)	$800 starting in first year in California	$900 - $11,790, depending on total income worldwide, if the income is $250,000 or more
limited partnership	$800 starting in first year in California	(none)

*banks and financial corporations have higher rates

If your entity is domiciled outside of California, it must also pay taxes and fees to the place of domicile. For example, Delaware corporations must pay an annual franchise tax of $35-$165,000, calculated by either the “authorized shares method” or the “assumed par value capital method”. Delaware LLC's and limited partnerships incur an annual tax of $200.

In Nevada, corporations owe (i) an annual fee of $125 to file a list of officers and directors; (ii) an annual fee of $100 for a business license; and (iii) an initial filing fee of $75-$35,000, determined by the value of their authorized shares. Nevada LLC's must pay annual fees of $125 to file a list of members or managers, and $100 for the business license unless the LLC has only one owner. Nevada limited partnerships owe annual fees of $125 for their list of general partners, and $100 for the business license.

Every jurisdiction requires an in-state agent for service of process. States usually allow the individual owners or managers of a company to serve as its agent, if they reside in the state. Alternatively, the company may arrange for a licensed company to act as the agent for an annual fee of approximately $50-$300.

California requires in-state employers to carry workers' compensation insurance and withhold certain employment taxes. These requirements apply to all companies with employees in the state, regardless of where the companies are organized.

Marketing Issues

From a marketing perspective, consider the relative attractiveness of each location.

For entities doing business in California, California has the home-state advantage. Establishing the domicile elsewhere might set off alarms with investors, business partners, and other third parties that favor “local” businesses and are skeptical of entities organized in other locations.

On the other hand, if your entity has founders or investors in other states, consider Delaware as a neutral place of organization. In fact, if your entity plans to raise capital from professional investors, note that such investors may prefer Delaware for various reasons, such as (i) their familiarity with Delaware laws and courts; (ii) the stronger legal protection of directors (which would be relevant to investors serving as directors); and (iii) the better performance of Delaware companies in IPO's (which would be relevant to entities that might go public).

Nevada provides fewer marketing benefits. The “Nevada” brand may be desirable for entities doing business in industries associated with the state, such as gaming and adult entertainment.