Wednesday, February 17, 2016

Should You Incorporate in DE, CA, NV or Elsewhere?

Table of Contents:
  1. Introduction
  2. Director Liability
  3. Piercing the Corporate Veil
  4. Director Indemnification
  5. Anti-Takeover Measures
  6. Shareholder Voting
  7. Courts
  8. Fees and Taxes


Most publicly traded companies are incorporated in Delaware, but that does not necessarily mean that you should, too. While incentives to incorporate in other states are often great, a California-based business will most likely benefit from incorporating in this state because the business will be governed by the California’s pseudo-foreign corporation law. This means that, if you are based in, or “actively engaging in any transaction for the purpose of financial gain” in California, this state will largely disregard the fact that you incorporated in another state, treat your corporation as if it was incorporated in California, and you could end up paying franchise taxes in both states as well as a fee to qualify to conduct business in CA. Thus, as a general rule, a California-based business will be better off incorporating locally.
However, some out-of-state and international businesses can benefit from looking around for a state with the most favorable laws.

Director Liability

Nevada automatically limits liability of directors and officers for damages to own corporation, unless the directors intentionally breached their fiduciary duty to the company by knowingly violating the law or committing fraud. Both California and Delaware allow articles of incorporation to contain such exculpatory provisions for directors’ negligence but this protection is not automatic as in Nevada. California only permits limitation of directors’ liability to the corporation but Delaware allows exculpation of liability to both corporation and its stockholders.

Piercing the Corporate Veil

It’s important to incorporate correctly because otherwise the court can disregard the corporate formalities and hold you personally liable for the debts of the corporation. This is called “piercing the corporate veil.” A 2010 academic study[1] found that courts pierce the veil in approximately half of all cases, and exclusively against close corporations, most of which are small private businesses.
California courts pierce the veil in 50.86% of cases. Nevada veil-piercing rate is 43.75%, and Delaware’s is 34.29%.[2]

Director Indemnification

Indemnification means that a company must pay a director to defend against legal proceedings arising from the action or omission of the director in the course of his service to the corporation. The rationale for this is to persuade responsible persons to serve on the board with less fear of being sued personally.
In California, a company must indemnify a director who has been successful in defending “on the merits” (as opposed to “on technicalities”). Additional indemnification may be authorized by the articles of incorporation as long as it does not exceed the minimal limits of director liability described in the section above. California law prohibits indemnification for amounts paid in settlements if a derivative action is settled without court approval, unless such indemnification is authorized by the court on a case by case basis.
 In Delaware, a corporate agent must be indemnified if “successful on the merits or otherwise.” Furthermore, Delaware, unlike California, permits indemnification even if the director is unable to demonstrate that s/he intended to benefit the company.
Nevada applies essentially the same standard as Delaware, even when the director is not under the Nevada’s automatic exculpation umbrella.

Anti-Takeover Measures

Delaware and Nevada have enacted laws that help the boards to protect the company against unwanted acquisitions. Anti-takeover measures (“shark repellents”) can include super-majority voting requirements, charter provisions for staggered boards, “poison pills” and “scorched earth” policies, – all designed to make the proposed takeover unattractive to the acquiring firm. Anti-takeover protections are strong in Delaware, perhaps to a greater extent so in Nevada, but the California law is currently not as settled on the issue.

Shareholder Voting

California, like many other states, only requires shareholder approval for certain major actions, such as a sale of all or substantially all of the assets. The default quorum requirement for shareholder meeting is essentially the same in California, Delaware and Nevada: a majority of the shares entitled to vote, represented in person or by proxy. Articles of incorporation may provide for a different quorum requirement, but in Delaware and California the quorum cannot be less than 1/3 of shares entitled to vote. In Nevada, however, the articles of incorporation may provide for a quorum as small as one share.


California does not have a special commercial court, so disputes are likely to be heard by judges with less corporate law experience than those in the renowned Delaware Court of Chancery. However, the Delaware Chancery Court creates so much complex business law that staying on top of it can be daunting even for somebody with a specialized legal training. In late 2000, Nevada’s Supreme Court created two specialized business courts – in Reno and Las Vegas.

Fees and Taxes

California imposes a flat fee of $100 to file the articles of incorporation, regardless of the corporation’s size. The minimum franchise tax (not to be confused with the corporate income tax) for the privilege of holding a corporate charter is $800 per year.
Delaware and Nevada calculate the filing fee based on the number of shares authorized. The minimum franchise tax in Delaware is $75 for corporations using the Authorized Shares method and $350 minimum for corporations using the Assumed Par Value Capital Method. Delaware corporate income tax rate is 8.7%. Nevada levies no franchise tax and no business income tax.

Once you decide where to incorporate, take a look at the Checklist for Drafting an LLC Operating Agreement, Partnership Agreement, Bylaws.

[1] See Peter B. Oh, Veil-Piercing, 89 Tex. L. Rev. 81 (2010).
[2] Id.