You have likely heard the phrase “Delaware Corporation” in your business travels. You don’t necessarily hear “Iowa Corporation,” “Virginia Corporation” or “Maine Corporation.” So why is it that more than two-thirds of the Fortune 500 companies in America (and a million more not in the Fortune 500) opt to incorporate in one of the smallest states in the Union (while typically not conducting any actual business there)? The answer is rooted in money—specifically minimizing the liability of a corporation and its officers.
The story of the “Delaware Corporation” dates back more than 120 years to when Delaware, in an effort to boost state revenue, passed the Delaware General Corporation Law. The plan was to make the state the most attractive option for companies to incorporate their businesses in. While much has changed in the last century, Delaware is still widely considered to be the most advantageous state for business formation.
Delaware’s primary advantages are:
- Tax Breaks. Businesses formed in Delaware that do not actually conduct business there are not required to pay state corporate income tax. Additional tax benefits include: No sales tax; no tax on interest/other investment income; no value-added taxes; no personal property tax; and no inheritance tax.
- Privacy. Delaware laws don’t require an entity to disclose the names of its officer or directors in the formation paperwork. Depending on the type of business you are part of, you may, for a variety of legitimate reasons, want to keep your name out of the public record.
- The Court of Chancery. No one plans on getting sued, but it does happen. If your corporation faces a legal challenge, the Delaware court system utilizes judges over juries, and you will likely benefit from a judge with an expertise in corporate law. Likewise, because of the popularity of Delaware Corporations, your business attorney is more likely to be familiar with the nuances and rules in Delaware, better positioning you for a positive outcome.
The “Delaware Loophole”
The most glaring benefit in the Delaware Corporation rules is known as the “Delaware Loophole.” In a nutshell, it works like this:
A company formed in New York (for example) can form a subsidiary corporation in Delaware. The rules then allow the company to transfer its intangible assets – things like trademarks and naming rights, to the Delaware Corp. The company can then legally pay its own subsidiary to license those intangible assets back to the parent company. In Delaware, intangible assets are not taxable. The company can also use the money it paid to its Delaware subsidiary as a tax deduction to reduce its tax liability in its home state.
Perhaps the most famous example of this is in the former Toys “R” Us Corporation. The retail toy giant used the Delaware Loophole to avoid paying millions in taxes—a move that led to a legal challenge in its home state of South Carolina. This piece, from the American Bar Association Journal, offers some historical perspective on the Toys “R” Us case.
In 2013, one study found that a company utilizing a tax strategy that incorporated Delaware into it, reduced its state income tax obligation by between 15-25 percent. Those numbers may be shrinking as some state look to push back against the Delaware Loophole, but there are still millions to be saved in state income taxes for large corporations.
The bottom line is, for many (but certainly not all) companies, forming a corporation in Delaware makes good business sense. If you are looking to form a corporation, or would like to learn more about the potential advantages of forming a Delaware-based subsidiary to see if it is right for your unique circumstances, give me a call. Our team of corporate and tax attorneys are here to assist.
Trevor M. Torcello is a shareholder of Gross Shuman P.C. who focuses his practice in the areas of commercial real estate, business transactions, agribusiness and working with emerging businesses. He has extensive experience representing various parties in complex business transactions. He can be reached at 716.854.4300 ext. 227 or email@example.com.