Disadvantages of Delaware LLC
There’s a lot of noise on the internet concerning forming a Delaware LLC. The buzz is all over because there are good reasons why Delaware is the American business hub. However, if there’s an excellent side to incorporating in Delaware, Delaware LLC must also have disadvantages.
Many businesses (LLCs and Corporations) are registered in Delaware because the state offers a more friendly business environment. Some good reasons business owners prefer incorporating in Delaware include more affordable franchise tax filing fees and foreign LLCs not paying taxes for revenue generated outside the state.
Entrepreneurs outside Delaware might have few favorable outcomes when incorporating a Delaware LLC. Registering as a foreign LLC is costly in terms of time investment and extra filing charges upfront and on an ongoing basis. The double charges are because the LLC is registered in Delaware and your home state.
But can keeping your Delaware LLC anonymous help solve the issue? Stick around to learn the disadvantages of Delaware LLC and if there are ways to work around them.
First, let’s define a Delaware LLC.
What is a Delaware LLC?
A Limited Liability Company (LLC) is a business entity separate from its owners before the law. Therefore, the business owners aren’t responsible for its debts or liabilities. As for a Delaware LLC, it means the LLC is registered in Delaware.
Delaware is famous for being the best state to register out-of-state incorporations. WHY? Delaware courts and statutes provide stockholders with more freedom. A dedicated court in Delaware adjudicates business debates, including LLC confrontations, and is known as the Chancery Court. The Chancery Court has been in operation for over two centuries.
Moreover, Delaware is a popular hybrid for LLCs because they’re taxed as pass-through entities. For this reason, Delaware is regarded as a hybrid business for LLC and C Corporation. LLCs are legal partnerships with a single or multiple owners or members, and there’s no limit to how many people can own the business structure.
Delaware LLC Formation Certificate Filing
Among all US states, Delaware is the only state that requires the least information to form an LLC. The business formation documents, otherwise known as the Articles of Organization, are filed and approved by Delaware’s Secretary of State.
You’ll not be required to provide your personal information, meaning your identity will not be publicized. Additionally, Delaware LLCs aren’t required to file annual reports detailing the previous year with state authorities. Here are the details you need to provide when filing for your Certificate of Formation:
- The Delaware LLC name
- A registered office address (Physical)
- LLC duration (only applicable when the LLC intends to operate for a specific period and then dissolve).
- Formation date
- Name and physical address of your Delaware registered agent who will receive formal and legal correspondence for the business.
- Name and signature of whoever is forming the LLC
The Authorized Person’s name will appear under the ‘Authorized Person’ section after completing the Certificate of Formation. But, if you wish to leverage anonymity as offered by the Delaware Limited Liability Company Act, a registered agent can prepare the Certificate of Formation on your behalf.
When you decide to be anonymous, your registered agent’s name will appear as authorized, meaning the owner’s true identity is protected.
During the filing of the formation certificate in Delaware, an LLC operating agreement isn’t necessary. An operating agreement is an internal document that offers guidance to LLC members. However, it’s vital to make the document official before a lawyer so that all members understand the ownership and operating procedures of the LLC.
Advantages of Delaware LLC
The State of Delaware didn’t wake up to find itself at the top of preferred states for incorporating businesses. However, becoming the preferred state for registering businesses has taken years of hard work. You enjoy these advantages for incorporating a Delaware LLC:
- Tax benefits: Corporations registered but don’t operate in Delaware aren’t required to pay income tax. Plus, shareholders living outside Delaware don’t have to pay tax on shares in the state, which is why Delaware is referred to as a tax haven.
- The presence of a corporation court: The Delaware Chancery Court operates under corporate law. Judges of the court are corporate law experts, and the court’s decisions are more predictable than in other states.
- Fast processing of filings: Since Delaware has corporation-friendly laws, your company filings are done in one day.
- Privacy is protected: Filing in Delaware assures you of privacy protection, and you don’t need to publish the names of your company directors and officers to the state. Thus, your business can operate in anonymity.
- No residency is required: Unlike other states, Delaware doesn’t demand such a thing, where company officers, shareholders, and directors must be residents.
- Slim corporate structure: Delaware law states a single person can be a director, officer, and shareholder. Startups find this arrangement attractive, explaining why Delaware is home to small businesses.
- Investors prefer Delaware: If you’re looking for business funding, angel investors or venture capitalists prefer to fund businesses incorporated in Delaware.
Disadvantages of Delaware LLC
Delaware is hailed as the American capital for LLCs and corporations. However, before you rush to register a Delaware LLC, it’s crucial to consider factors that can help your business succeed. With that in mind, some of the most important questions include:
- Should you incorporate a company?
- Which state is ideal to form your business in?
- Which business structure is the most compatible with your business goals?
Many entrepreneurs choose the LLC business structure because it has many advantages, such as separating the business and owners.
Although Delaware has unique advantages related to LLC formation, there are also disadvantages. So, to ensure you make the right decision that benefits your business. Here are the disadvantages of forming a Delaware LLC:
1. More Expensive
Forming a Delaware LLC is much more expensive due to the following situations:
- Many cases within the parent company. Members of series LLCs pay higher administrative fees. Accounting charges may increase if the accountant isn’t familiar with the series LLC framework.
- LLCs don’t pay income tax in Delaware state but are subject to franchise tax depending on their share value. Although small businesses pay low franchise tax, the amount rises as the company shares and stock value increase. Depending on your home state, your business may also be subject to franchise tax.
- Foreign Qualification Fees – If you have a site in Delaware, you must register to operate a business there. You need a non-resident qualification to operate a business in a different state from the one it was formed. In some cases, international qualifying costs and recurring fees may be applicable.
- Filing fees for incorporation documents like articles of association are more expensive.
- All Delaware LLC residents must have a state business license and an operating agreement.
- Delaware has the highest unemployment tax rates in the US, and LLC members pay large sums in self-employment taxes at the federal level.
- Delaware LLCs must pay an entity tax fee of $300 annually. Even entrepreneurs who don’t collect sales taxes from consumers must pay a receipts tax. You must pay workers’ compensation insurance once the business grows and employs workers.
2. Dual Registration
If you live outside Delaware and incorporate an LLC in Delaware, you may be subject to dual registration. You register the business in Delaware and your home state, meaning you must file two annual reports and two state tax returns for the company.
Moreover, you also pay for two sets of filing costs to register and renew. If a Delaware LLC wants to do business in another state, the company must be registered as a foreign corporation. Registration troubles don’t end there; but you might have to retain two registered agents or attorneys.
3. The Delaware Registered Tax Agent
You must hire a tax-registered agent if your LLC is registered in a state other than Delaware while keeping a registered agent in Delaware to maintain dual registration. It means you’ll need someone in each state with a company address that you can reach for legal matters. Also, the registered agents take care of the legal paperwork, which may increase company’s costs.
4. Extra Reporting Documents
If you incorporate in Delaware, but your business headquarters are in a different state, you’re subject to the state’s requirements to operate there. Plus, you must file annual reports in both states; both cases take the same time and twice the costs to complete. Additionally, you must consider the annual fee for registered agents and attorneys, which might amount to $129 a year.
Even in cases where you have to handle litigation, you must follow both states’ rules. If a settlement is applied to the case, you keep a Delaware LLC and one out-of-state. Although keeping both businesses can be helpful in some situations, it may be challenging for small entrepreneurs as it may result in higher expenses, which is a disadvantage for your company.
5. Challenges in Obtaining Separate Identification Numbers
Getting a different tax ID for a Delaware LLC structure may be tough and challenging. The registered company might not get unique ID numbers. To pay federal taxes for a Delaware LLC, the company can only get a tax ID if they’re part of a series LLC. WHY? Because each member of a series LLC is considered a separate LLC and those in charge need a federal tax identification number, it can be challenging to get.
6. No Tested Business Structure
The benefits of forming a Delaware LLC are exceptional. However, Series LLCs have setbacks, making them a double-edged sword. Whatever type of LLC you create, a series or standard LLC in Delaware, the business’s distinctive structure has been tested. Courts will dismiss each series’ assets, liabilities, and records, ignoring the formal division to consider the umbrella LLC as the leading business venture.
7. No Real Tax Savings for Small Businesses
Although Delaware LLCs don’t tax incorporated businesses within the state, the company that doesn't operate in your home state will still tax your business. Hence, there’s no way to escape taxes.
8. Legal Disputes and Traveling
Whenever your business faces legal conflicts, they must be reviewed in Delaware. If you live out of state, you must travel to resolve the issue in Delaware. Plus, you can’t use the lawyer you have in your home state. Instead, you must hire an attorney from Delaware to handle the issue.
For instance, conducting business without authority means you’re operating an LLC that is not registered in that state and must apply for authority for a foreign LLC. Simply put, you must travel to that particular state with all relevant documents, which translates to more expenses for the company and yourself.
9. Precipitate Foreign Qualification Fees
Operating a business away from your home state can prompt a foreign qualification. Check with your home state to know the formation documents you need to form a Delaware LLC. The application for foreign qualification can take up to ten business days to get approved. Plus, you must register your business as a foreign entity. The Qualification Certificate will cost you $245 and an extra $50 to expedite the process and get a certified copy.
10. Consignable Ownership
Changing ownership in an LLC is more challenging than in a corporation. Firms can sell stock shares to increase owners, and stockholders can sell their shares to someone else. However, this can only happen if an operation agreement states that all members agree to add members.
How Delaware Became America’s Incorporation Capital
According to the Delaware Division of Corporations, over a million businesses have chosen Delaware as their home, including over half of the Fortune 500s. Thanks to its business-friendly environment, the tiny state of Delaware hosts numerous high-profile companies like Google and Coca-Cola. Other reasons as to why investors choose to incorporate in Delaware state include:
- Business-friendly laws and policies
- Tax system
- A corporation court
As the first US state to vote in favor of the constitution, Delaware was also the first state to adopt General Corporation Law. Almost all US survey editions (excluding 2017) by the US Chamber Institute for Legal Reform (ILR) declared Delaware the state with the most business-friendly legal environment.
Delaware’s Court of Chancery
The Court of Chancery in Delaware continues to offer unique legal advantages to businesses. The trial court dates back to 1792; it still has no jury, and its legal system originated in England during the reign of King George I.
In its history, Delaware’s Court of Chancery has been an exclusive equity legal system that only handles lawsuits and petitions. The court only admits remedy requests in injunctions or court orders instead of damages. The court judges are experts in corporate law and are known as chancellors.
Why the Court of Chancery Stands Out?
It simplifies dealing with legal disputes for Delaware LLC owners. A civil trial can take several years to resolve in an ordinary US court. However, your business disputes can be resolved in weeks for Delaware-based companies. You can also expedite the appeals to the Delaware Supreme Court but must be physically present during the court dates.
The Court of Chancery provides a unique opportunity for Delaware LLCs to resolve disputes fast, as they have no backlog like other US courts. Another scenario is the presence of jurors who pass judgment or make business decisions without the proper knowledge of how companies function.
If a business case is tried in an ordinary courtroom, judges and lawyers must study corporate law for each trial. However, as you know, all cases are unique, and the situation can increase unpredictability and cause delays in corporate cases.
The more businesses are incorporated in Delaware, the more corporate trials there are. Fortunately, the state has a large body of case law to help entrepreneurs handle legal issues. If you’d like to know if your business should fight a lawsuit or settle, the case law and your attorney will help you make the right decision.
Any business that expects to deal with litigations will be in good hands when incorporated in Delaware. It’s a smart business move to incorporate in Delaware, as you can leverage the consistency of law and resolution speed of disputes.
Tax Exemptions and the Delaware Loophole
Delaware is considered a domestic tax haven because the state offers business owners different ways to lower tax bills. Here are the various ways Delaware is a tax haven.
- Companies that operate outside Delaware don’t need to pay income tax.
- Delaware has no sales tax, meaning in-state purchases can’t be taxed regardless if you’re physically within or outside the state.
- Delaware doesn’t collect property tax. Therefore, you can pay for an office space at the county level, which only attracts a county-level real estate tax, which is lower.
- Delaware doesn’t impose these taxes - Inheritance taxes, Value-Added Taxes (VAT), or inventory.
Finally, about the “Delaware Loophole.”
The state doesn’t tax the income from fixed-income or equity investments, which has led to. Corporations started shell companies in Delaware, commonly known as Delaware holding companies. The shell companies collect income from intangible assets such as patents without paying taxes.
The Delaware Loophole is how companies evade tax liabilities in other states by establishing some parts of their businesses in Delaware. Naturally, the Delaware loophole favors large companies rather than the average startup.
The parent companies pay a royalty to their Delaware subsidiaries to enable them to lease back the assets. In states where these holding companies operate, the royalties are considered income, making them subject to income tax deductions. The shell companies can also funnel tax-free profits back to their parent companies by paying dividends and loans.
Frequently Asked Questions
Why forming a Delaware LLC isn’t wise for business?
It’s not wise to form a Delaware LLC if you don’t reside in the state because you have to register the business in your home state and Delaware. Although Delaware will not require you to pay sales tax for your Delaware LLC, your state might ask you to, meaning you don’t escape taxation. Plus, registering in your home state and Delaware means you pay everything twice, which is not business-friendly for a small business.
Why do most people prefer LLCs?
Most people prefer LLCs because they offer protection from separating business and personal assets and finances. Whenever the company is in financial trouble, your finances and assets will not be targeted to settle the debt. Business liabilities only affect the business and have nothing to do with your finances.
Will my Delaware LLC pay taxes?
A Delaware LLC is not required to pay taxes since the state doesn’t collect sales tax. A single-member LLC is considered a sole proprietorship for tax purposes. You’ll not be required to file for returns with the Delaware state without paying taxes.
Why are most US businesses incorporated in Delaware?
Most US businesses are incorporated in Delaware because it’s termed as a tax haven. The tiny state is known for its business-friendly environment, corporate laws, and the Chancery Court, which handles only corporation disputes.
Can a foreigner own a Delaware LLC?
A foreigner can own and operate a Delaware LLC, as the state doesn’t discriminate against non-US citizens. Foreigners can have registered most Delaware Corporations and LLCs. Delaware doesn’t require a lot of paperwork during incorporation, and you can even leverage the anonymity policy. The public will never know who a valid business owner is.
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In Summary
While Delaware has one of the most business-friendly legal systems in the US, there’s additional complexity in filing and operating a Delaware LLC. Entrepreneurs who register their businesses in Delaware choose the state for its business-friendly environment and tax benefits.
However, if you live outside Delaware, you have to register your business in Delaware and your home state. Additionally, although Delaware doesn’t require you to pay sales tax, your home state might demand it, meaning you’re not enjoying the tax benefits.
Delaware LLCs benefit global investors, but anyone should consider all the disadvantages that come with the business-friendly state. In any situation where disadvantages outweigh the advantages, it’s essential to rethink the decision before engaging.
With that in mind, small businesses should not be driven by the internet buzz about Delaware being a tax haven, as it mainly benefits large corporations. Therefore, it’s wise to consider filing costs in two states, the time needed, and the disadvantages of Delaware LLC before rushing to incorporate a business in the tiny state.
So, before you decide to incorporate a Delaware LLC, you need to know and understand the disadvantages of launching a company in the state. From what you have learned, you can make informed business decisions on whether or not to incorporate a Delaware LLC. If you have a question on Delaware LLC, kindly contact one of our experts here.
