If you start searching the Internet for information on the best state to form your LLC in (limited liability company), chances are you will be bombarded with statements like these:
The truth is, for most entrepreneurs, the best state to form LLC entities is the one in which they reside. There are two very important exceptions to this rule. For businesses in those two categories, there are indeed better states than others for forming your LLC. But choosing to create your LLC outside your home state can backfire if you are not careful because of one fundamental principle.
Table of Contents
- Taxes are paid where income is made (and sometimes also where it isn’t).
- The physical presence rule can set you up for double taxation.
- Domestic LLC vs. Foreign LLC?
- Some “no-tax” states actually charge taxes.
- LLC taxed as a corporation
- If you are a non-resident alien, certain states are better for forming an LLC than others.
- So, the 10 best states to form your LLC in are:
- Real estate investors often benefit from LLCs in multiple states.
- What state should I form an LLC in?
Taxes are paid where income is made (and sometimes also where it isn’t).
The most important principle to keep in mind when you are choosing the state in which to form your LLC is that you generally will pay taxes on your income where you earn it. The question isn’t where your customers live, the question is where you live.
Of the 41 states that collect income tax, 36 have a “physical presence” rule. The physical presence rule comes down to this: If you live in a state, you will be considered to have earned your income there. No matter where you form your LLC, if your home state has an income tax, you will pay it on the profit from your company.
Five states do not have a physical presence rule. These states are:
- New Hampshire
Even in these states, you can easily form a “nexus” with the state that exposes you to both personal liabilities for court judgments and state income tax.
There is only one kind of business owner who is entirely free to choose the state with the best combination of registration costs and low or no state taxes. And there is one kind of business for which out-of-state formation of an LLC is often a good idea.
We’ll cover these exceptions to the rules a little later in this article. But for most new business owners, the first mistake to avoid having your efforts to avoid paying any state taxes at all wind up making you liable for double taxation.
The physical presence rule can set you up for double taxation.
How does the physical presence rule create the potential for double taxation of businesses that create their LLC outside their owner’s home state? The clearest example of the havoc that is forming an LLC outside your home state causes is the situation of California business owners who form an LLC in Nevada to avoid California taxes.
Let’s suppose you are a California entrepreneur with a great idea for an online business. You can see eventually making a million dollars a year in profits. Thinking ahead, you don’t want to pay 12.3 percent of that to the State of California when you hit it big.
You also want to avoid hassles along the way. The Federal government gives you a tax break that allows you to treat your LLC as a corporation. If you take advantage of this tax break, you can be your own employee. As long as you pay yourself a reasonable salary, you can avoid self-employment tax, get a full tax break on your health insurance costs, and pump up your retirement accounts.
The problem with treating your LLC as a corporation
But if you are your own employee in California, you will have to do things like (we’re not making this up) give yourself a one-hour lecture every year on safety in your workplace. You will need to be sure to point out to yourself the fire exits from your desk, and you will need to instruct yourself on how to avoid paper cuts.
Additionally, you will need to write yourself an employee handbook, give yourself a meal and rest breaks. You will also pay state disability insurance. And since January of 2020, the State of California will not allow you to avoid these obligations by becoming your own contractor.
The obvious solution for a California entrepreneur seems to be to form an LLC in Nevada. Unfortunately, this solution won’t work. Here are a few of the reasons why.
Domestic LLC vs. Foreign LLC?
California is one of the majority of US states that has a physical presence test. If you live in the state, it is assumed that you work in that state. If you want protection for your personal assets and eligibility for federal breaks from an LLC, you will need to have an LLC registered in that state. There is more than one way to do that.
One way to get LLC protection is to form an LLC in the state where you live. This is a “domestic LLC.” Another way to get LLC protection is to register your out-of-state LLC in the state where you live. In this case, you will have a “foreign LLC.”
Foreign LLC Process
A resident of California can protect California assets with a Nevada LLC by doing a second set of registrations of the Nevada domestic LLC as a California foreign LLC. Here’s what that involves:
- First, you form your domestic LLC in Nevada. You pay fees to the State of Nevada, and you hire a registered agent in Nevada. Having an LLC in Nevada won’t protect you from getting sued in Nevada (one of the things a registered agent does is to receive process when you are served with a suit), but you will at least have protection for your assets. If they are in Nevada.
- Then you still have to form your foreign LLC in California. You pay another set of fees to the State of California to register your foreign LLC. A few months later, you pay the same $800 annual franchise tax you would pay if you had set up your LLC in California in the first place. But you also have protection for your California assets if you get sued in California.
In this example, our California businessperson has gone through a lengthy process to protect assets in Nevada that she doesn’t have, and then repeated the process to protect assets she does have in California. Failing to protect her California assets could have catastrophic consequences. Creating an LLC in Nevada has been an unproductive expense. But there is a common situation in which forming an LLC in a no-tax state actually increases taxes.
Some “no-tax” states actually charge taxes.
The attraction of forming an LLC in a no-tax state is not paying taxes. But it is necessary to consider all the kinds of taxes states impose when choosing a domicile for your LLC to minimize your tax rates.
California has personal income tax rates up to a little over 12 percent. Nevada has no personal income tax at all. Until the beginning of 2018, an LLC was a “disregarded entity” for purposes of federal personal income tax. The income and expenses of the LLC were just “passed through” to its owners.
However, since 2018, owners of LLCs have been able to elect to be taxed under Subchapter C or Subchapter S of the Internal Revenue Code. Making this election, as alluded above, allows the owners of LLCs to treat themselves as employees on salary.
They do not have to pay self-employment tax on profits over and above their wages. They get more significant deductions for certain business expenses if they file an election with the IRS for their LLC to be taxed as if it were a corporation.
The problem is that the states will tax their LLCs that make this election as if they were corporations, too.
LLC taxed as a corporation
Nevada has a 5 percent tax on corporations. If a Nevada LLC owner elects to get federal tax breaks, then there is a new liability for Nevada taxes. This situation also arises in Alaska, Florida, and Tennessee. These states don’t have personal income taxes, but they have corporate income taxes. In Tennessee, you can even owe corporate income tax equal to 6.5 percent of your gross income if your expenses exceed your income.
For most situations, the value of the federal tax breaks exceeds the cost of state corporate income tax. In Alaska, which has no personal income tax but an unusually high corporate tax rate, it may not. There are other states in which entrepreneurs need to look closely at state corporate tax rates when they are setting up an out-of-state LLC. Of course, if you live in the state where you form your LLC, you at least won’t pay additional out-of-state taxes if you elect to e taxed under Subchapters C or S by the IRS.
It’s sometimes tempting to look at these situations and say, “It’s only a problem if the state tax agencies catch me.” Don’t take that risk. They’ll catch you. Typically, state income tax problems emerge after the resolution of a lawsuit, which is a time when you especially do not need tax problems.
Potential licensing hurdles with an out-of-state LLC
There are also situations in which you will need to have registered your LLC in the state where you live to get essential state licenses. If you need a Seller’s Permit (also known as a Reseller’s Permit or Resale Certificate), for example, you cannot get it without registering your LLC in the state where you live. Either as a foreign LLC or after dissolving your out-of-state LLC and starting a new LLC in the state where you live. If you get a Reseller’s Permit, the state may start looking at your income.
But there are still situations in which it makes sense to create your LLC in a state other than the one in which you live.
If you are a non-resident alien, certain states are better for forming an LLC than others.
By definition, non-resident aliens do not reside in any US state or territory. Non-resident aliens also have the right to set up LLCs in any of the states of the United States, plus the District of Columbia and US territories. Non-resident aliens may want to set up LLCs in the United States to create an entity for banking and to distinguish their business assets from any personal assets they hold in the United States.
For example, if you have both an online business that generates income in the United States and a condo you use when you visit the United States, you may want to make sure that your condo is protected as your non-business property.
The US can be one of the world’s best tax havens for non-resident business owners. No federal or state taxes are charged against profits earned without a “dependent agent” in the United States. A dependent agent is a person you employ substantially fulltime to increase your income, as contrasted to doing something purely administrative, like making sure payments are deposited into your bank account.
Two examples of profitable businesses that earn income in the US that are exempt from all US taxation:
- You run a “fulfilled by Amazon business.” Maybe you wrote the definitive book on SEO, and you earn tens of thousands of dollars per month from your Amazon Kindle royalties (as one resident of the UK does). Or maybe you stock specialty goods in Amazon warehouses that are “fulfilled by Amazon” without any additional effort by you. An LLC gives you protection against legal claims on your US assets, which might be the royalties or profits on sales that are in transit from Amazon to your bank account. Since you are not operating a business in the US, you only have to file an information tax return with the IRS. You are not subject to tax or withholding.
- You provide services over the Internet. Let’s suppose you are a programmer in Belarus. You write software for US companies and get payments through Stripe, PayPal, and bank transfers. All your sales are made by phone or online and you don’t have a dedicated sales agent in the US. You maintain an LLC for collecting payments and making sure the IRS and your clients know that you are not subject to 30 percent withholding imposed on non-resident aliens who run brick-and-mortar businesses in the United States.
In these situations, some states are better for forming your LLC than others. First, you do not want any confusion about owing state income taxes. Even if you don’t owe them, you do not want to have to prove that you do not. You should form your LLC in a state that does not have a state income tax.
So, the 10 best states to form your LLC in are:
- New Hampshire
- South Dakota
- New Mexico
The IRS does not allow you to claim Subchapter S benefits, so corporate income taxes in those states are not a consideration.
How much it costs to form your LLC and what the state’s annual fees will be.
- Alaska charges $250 to form your LLC and $100 a year to keep it.
- Florida charges $125 to form your LLC and $138.75 per year to keep it.
- Nevada charges $425 to form your LLC and $325 per year to keep it.
- New Hampshire charges $100 to form your LLC and $100 per year to keep it.
- South Dakota charges $150 to form your LLC and $50 a year to keep it.
- Tennessee charges $300 to form your LLC and a minimum of $300 a year to keep it.
- Texas charges $300 to form your LLC with no additional fees in future years, although you need to file annual reports.
- Washington State charges $200 to form your LLC and $60 per year to keep it.
- Wyoming charges $100 to form your LLC and $100 per year to keep it. And let’s look at one more state that has a personal income tax but has an unusually low fee structure for forming an LLC:
- New Mexico charges $50 to form your LLC with no additional fees to maintain your LLC status. It also does not require future annual reports.
The lowest up-front costs for forming your LLC are in New Mexico, New Hampshire, Wyoming, and Florida. There are no annual fees in New Mexico or Texas, but Texas requires annual reports. All of these states need you to appoint a registered agent, but that cost usually is less than $100 per year.
So which is the best state for forming an LLC if you are a non-resident alien?
Answer: The least expensive state over the long run is New Mexico, followed by Texas, then Wyoming and New Hampshire (tied), then Florida. The lowest annual reporting cost is with New Mexico.
The reason you wouldn’t form your LLC in New Mexico would be that you happen to own a vacation home in New Mexico. You also wouldn’t want to form your LLC in Texas, Wyoming, New Hampshire, or Florida if you owned real estate or personal property in those states.
Non-resident aliens want to avoid any appearance of a “nexus” of their personal activities and their business activities in any state. But usually, the best state for forming an LLC, if you are a non-resident alien, is the state with the lowest fees.
Real estate investors often benefit from LLCs in multiple states.
Rental real estate can be riskier than most investors realize. Here’s a true story.
Jane (not her real name) inherited an apartment building and her parents’ home in Austin, Texas. One of her tenants fell asleep while smoking a joint and deep-frying a Thanksgiving turkey indoors. The apartment building burned down and he tenant was horribly burned. The tenant sued on the theory that Jane should have prevented her from falling asleep while smoking a joint while deep-frying a turkey over an open gas flame in a studio apartment.
She had fire insurance to cover her loss of the apartment building, but she did not have liability coverage to cover her legal fees. Jane won her court case, but she had to file bankruptcy to cover the legal expenses and, despite her state’s homestead protection laws, also lost her parents’ house.
Jane could have prevented bankruptcy by forming an LLC for her apartment house. Since Jane’s apartment house was in Texas, she needed to form a Texas LLC to protect her assets from judgments against it. As a general rule, real estate investors need to form LLCs for properties they own in the states where they own them.
Jane could have had an additional layer of protection by forming an LLC to own her LLC. For example, Jane could have formed a Wyoming LLC to own her LLC in Texas. Any plaintiff seeking damages concerning her property in Texas would have to go through the Wyoming LLC to collect.
The purpose of this arrangement is not to prevent legitimate plaintiffs from getting what they are due. The use of having an out-of-state LLC own a same-state LLC is to consolidate asset protection and also to create a single conduit for income and losses to the owner’s personal tax return.
What state should I form an LLC in?
You don’t want the LLC that owns your other LLCs to own property in that state. And you don’t want to be cavalier about claiming asset protection. Keep the business activities of your LLCs clearly business-related. But the choice of state for your LLC should be (1) where you have no assets to be attached and (2) where you have no state income tax liability and low fees to form and maintain your limited liability company.
New Mexico, Texas, Wyoming, New Hampshire, and Florida top the list. Because the courts in Wyoming tend to be friendly to business owners, many real estate investors form their LLCs in Wyoming.
Complex and changing laws govern issues of taxes and liability. It pays to consult with an attorney and a tax planner who can give careful attention to your unique situation. The general principle for forming LLCs is that it is best to form your LLC in the state in which you live, but don’t be hesitant to explore potentially profitable exceptions to the rule.