December 1, 2008

Incorporation Roulette: Deciding Where to Incorporate Shouldn't Be a Gamble

Increasingly, new businesses are faced with an ever-widening variety of decisions that need to be made before they commence business. Not only must businesses choose between various entity forms, but they also must choose a state in which to register or incorporate. Traditionally, larger corporations have looked to Delaware as a home state, regardless of their physical location, because of Delaware's long history of favorable corporate laws, established case law, and specialized business courts with significant expertise. Smaller corporations, on the other hand, typically looked to the state in which they physically reside to be their home state, both because they do not need the advantages presented by Delaware and because of the relative ease of handling the process through a local attorney who is familiar with California law. In recent years, however, the choice of where to incorporate has become harder to make intelligently, as both incorporating services and the states themselves compete for business. Nevada, in particular, has become attractive for many businesses operating in California. Accordingly, it is worth taking the time to carefully review and compare the regulations of each jurisdiction under consideration so that there are no surprises down the line. As Nevada, in particular, has attracted the attention of many businesses operating in California, this article provides a brief overview of the merits of choosing Nevada - or California -- as a home state.

Nevada has become a popular state in which to incorporate primarily because of lower taxes and management-friendly statutes that provide for high standards of immunity for managers and greater privacy for shareholders in the form of minimal disclosure requirements. However, many of these advantages do not translate into concrete benefits for corporations doing business in California. Here's why.

First, Nevada corporations who do business in California must still pay California taxes and must comply with a variety of California laws. At a minimum, a Nevada corporation doing business in California must register as a foreign corporation and must pay a proportional tax based on the amount of business it conducts in the state. Cal. Rev. & Tax Code § 23151(a).

Second, while Nevada does not have personal income tax, this advantage would only be useful if the shareholders are Nevada residents - California residents must still pay California income tax, even if that income is earned outside of the state. Cal. Rev. & Tax Code § 17041.

Third, both California and Nevada require corporations to file regular reports identifying current officers and directors. Nev. Rev. Stat. § 78.150; Cal. Corp. Code § 1502. Neither state requires shareholders, directors or officers to live in the state and meetings may be held within or without the state. Nev. Rev. Stat. § 78.310; Cal. Corp. Code § 307(a)(5). Both states also protect shareholder privacy, as shareholders are not a matter of public record in either jurisdiction.

Fourth, while Nevada does provide slightly more liability protection for management, for many corporations this is not significant. For example, Nevada law provides that officers and directors are not liable for damages resulting from conduct unless such conduct constitutes a breach of fiduciary duty that involved intentional misconduct, fraud, or a knowing violation of the law. Nev. Rev. Stat § 78.138(7). In California, a corporation can limit its directors' liability in the articles of incorporation, but cannot limit liability for, among other things, intentional misconduct, bad faith or breach of the duty of loyalty, reckless disregard for or abdication of duty, and certain specified transactions. Cal Corp. Code §§ 204 & 317. While California does not include officers within this liability limitation provision, it does permit a corporation to indemnify officers for similar liability. Cal. Corp. Code §§ 204 & 317.

Nevertheless, there are some differences between Nevada and California statutes that may make Nevada more attractive to a new corporation in certain circumstances.

First, California and Nevada differ with respect the standard of care imposed upon corporate directors. In Nevada, a director must act in good faith, but is presumed to do so. Nev. Rev. Stat. § 78.138(3) In California, directors are required to act in good faith in the best interests of the corporation, and with such care that an ordinarily prudent person in a like situation would use in similar circumstances. Cal. Corp. Code § 309. This provision is essentially the "business judgment rule" codified. There is no presumption of good faith. Thus, Nevada states are more lenient. However, it is questionable that, with respect to most director and officer conduct, this would make a material difference in terms of a deciding where to incorporate.

Second, Nevada differs from California in that it does not require cumulative voting. Cumulative voting is a minority shareholder protection. Cumulative voting allows a shareholder to cumulate his or her votes and give one candidate (or distribute among candidates) a number of votes equal to the number of directors to be elected multiplied by the number of votes to which the shareholder's shares are normally entitled. Cal. Corp. Code § 708. Cumulative voting thus expands the ability of a minority shareholder to obtain representation on a corporation's board. Nevada does not mandate cumulative voting, but does permit a corporation to require it in the articles of incorporation. Nev. Rev. Stat. § 78.360.

Third, California and Nevada differ with respect to supermajority voting. In Nevada, a corporation may include a supermajority provision in the articles of incorporation or bylaws. Nev. Rev. Stat. § 78.320(1). In California, a corporation may provide for supermajority votes, but cannot do so with respect to the election or removal of directors or with respect to voluntary dissolution. Cal. Corp. Code § 204(a)(5).

We point out that while these differences may be attractive to some corporations, it is important to recognize that they will be material only if such corporations conduct most of their business outside of California. If, on the other hand, a corporation conducts the majority of its business in California, then California's statutes will apply regardless of the state of incorporation. Section 2115 of the California Corporation’s Code specifically applies many of the state's key corporation laws to a foreign corporation if: (1) the average of the corporation's business (measured in terms of property, sales, and payroll, as determined under the Revenue and Taxation Code) is more than 50 percent during the last full income year; and (2) more than 50 percent of its outstanding voting securities are held of record by persons residing in California. Cal. Corp. Code § 2115(a). If a foreign corporation meets this standard, then the following provisions of the California Corporation Code, among others, will apply:

1. Sections 301 & 303-305 pertaining to the election and removal of directors.
2. Section 309 establishing the directors' standard of care.
3. Section 316 regarding the liability of directors for unlawful distributions.
4. Section 317 regarding indemnification of directors, officers and other agents.
5. Sections 500-505 regarding limitations of corporation distributions in cash or property.
6. Section 506 regarding liability of shareholders who receive unlawful distributions.
7. Section 600(b)&(c) requirements concerning shareholder meetings.
8. Section 708(a) - (c) regarding shareholders' rights to cumulative votes.

As is clear from this extensive list, a foreign corporation that does a majority of its business in California is essentially treated as a domestic corporation in many key respects, including corporate governance. Thus, if a corporation intends to conduct most of its business in California, incorporating in Nevada - or in any other state for that matter -- would not be advantageous.

In short, a decision on where to incorporate is one that should be made based on full information. Such a decision should take into account the specific business objectives of the company, including where the shareholders live and where the locus of business operations will be. If California is the answer to both of these questions, then the corporation would most likely be better off by incorporating in California rather than taking a gamble on another jurisdiction, thereby incurring unnecessary costs (such as payment of unnecessary filing fees; hiring an agent for service of process in Nevada; duplicative reporting requirements).

For more information on State corporation law, or assistance in forming a new corporation or other business entity, please contact either Lawrence Inouye or Colleen Sechrest at 310.712.0100 or send an email to: linouye@shiotani-inouye.com or csechrest@shiotani-inouye.com.