HOW TO MAKE CHANGES TO YOUR BUSINESS ENTITY.
Most of this blog post comes from the book Unf*ck Your Biz.
I see new business owners make many business formation mistakes. Here are two. The first is forming in the wrong state. The second is choosing the wrong entity. Let’s start by digging into the first issue.
The million-dollar question is “In which state should you form?” As with most questions, the answer is typically that it depends. However, the answer does not depend on what most new business owners think. In fact, for many, the answer is pretty simple.
If you read business publications or if you’ve taken a college business course, you are likely familiar with the Delaware corporation. We all learn that big businesses love to form in Delaware. States like Nevada and Wyoming also have many business filings.
Businesses are governed by the rules of the state in which they’re formed. However, the more important—and often overlooked—truth is that businesses are also governed by the laws of the states in which they operate. This is why my first question I always ask new business owners is “Where do you plan to operate your business?”
You may be asking, “Why then would so many businesses wish to form in Delaware?” Delaware has laws that are pro-business. The state has its own courts staffed with judges who have niche expertise in business law. They hear and decide all the cases. Businesses prefer this to juries, who can be more unpredictable.
Juries tend to be great for the little guy, while bench trials (those decided by a judge) tend to render verdicts more favorable to larger businesses, as a judge will be less likely to allow sympathy for the plaintiff to cloud her judgment.
While differences in state business law are beneficial to large corporations, smaller businesses need not put as much energy and money into business disputes. Typically, an LLC or corporate formation, along with liability insurance, should mitigate any dispute concerns.
So if the Delaware corporation isn’t the magical business entity unicorn it’s always made out to be, where should you form your business?
The answer, in most cases, is wherever you plan to operate. Here’s why. You pay income taxes to the state in which you maintain domicile—translation: where you live. In addition, many states also have an annual franchise tax. In California, that tax for LLCs starts at $800. Many states also require “foreign LLCs” (LLCs formed in other states) to pay that state’s franchise tax if they’re doing business in that state. A business “does business” in California if it is based in California. If the business is not based in California, numerical metrics based on sales determine whether the business is doing business in the state.
What does this all mean? If you have an LLC formed in Delaware that you operate in California, you still pay all the same state income taxes in California if you live there. You also pay the California state franchise tax since the business would be considered a foreign LLC. The only difference is that now you also must meet whatever state fees, taxes, and requirements Delaware might have. In short, forming in a state where you don’t operate would cost you more money and more time without providing much, if any, benefit.
Choosing your formation state is a bit more complicated if you:
Are in the military,
Are a military-spouse (read this post), or
Live or spend a significant portion of time outside the U.S. (read this post)
When should you consider forming in one of the pro biz states? If you plan to operate in multiple states, sell products nationally, or form a US business but live or work abroad, there are important considerations to make. If you fall into one of those categories, seek the help of an attorney to make the right choice.
Choosing a business entity is an important decision. You need to decide not only where to file but which type of entity to form.
Forming in one state and later moving to another isn't necessarily a mistake, but the same principles apply. Move your legal docs over to your new state.
We’ve got more posts
Learn more about these topics specifically applicable to military spouse entrepreneurs in this post.
Learn more about these topics specifically applicable to digital nomads in this post.
If you’re curious about LLCs general, read our Legal Essentials post.
CHANGING STATES
Generally speaking, when you move states you have one of three options if you already have an LLC or corporation:
Transfer or domesticate your LLC from one state to the other.
Register in your new state and maintain your registration in the old state.
Dissolve the old business and form a new one.
Doing nothing is not a legal option. As noted, most states generally require you to register your business in that state when you’re operating in the state. Most states base operation on physical location, so where you're located and/or if you have a physical work location in the state. For most of us, all that’s relevant is where we physically live and work.
If you’re doing a high volume of business in another state, you may want to also check their rules.
1. TRANSFER OR DOMESTICATE YOUR LLC FROM ONE STATE TO ANOTHER
This is usually the best option if it is available in your state. Domestication is really a transfer. This is good because you’re effectively moving your business from one state to another.
If you don’t or can’t domesticate your business, you either have to register your business in two states, or dissolve your LLC and reform it in the new state. Dissolution means you take steps to actually form, dissolve, and reform the entity, open new bank accounts, get new licenses, and so forth.
Registering a business in two states is only really ideal if you’re actually operating in them both or plan to move back to your original state, and if the cost of being registered in both states is worth the hassle of not transferring.
To be able to domesticate your LLC both your original and new state must allow it. The following states appear to allow domestication (double-check your state before making any final decisions):
Arizona
California
Colorado
Delaware
District of Columbia
Florida
Idaho
Indiana
Kansas
Kentucky
Louisiana
Massachusetts
Maine
Mississippi
Nebraska
New Hampshire
New Jersey
Nevada
Pennsylvania
South Carolina
South Dakota
Texas
Utah
Virginia
Washington
Wisconsin
Wyoming
If you’re good to go with domestication, you typically want to start by registering your LLC in your new state. For example, in California that’s done with the Form LLC-1A. Then, find the corresponding form for your original state to let them know that you have domesticated out of their state and will no longer be doing business there.
Top tip: Call each secretary of state’s office to verify what you need to fill out.
Be clear about what you’re trying to accomplish and use your judgment to ascertain their confidence in what they're telling you. I have found most representatives to be informative and willing to help, but it’s usually evident when they’re not so sure themselves.
Once you have domesticated, you’re good to go. You still need to register with your new city for a business license if applicable, but your LLC, EIN, operating agreement, and bank accounts should be all set.
If you don’t have an LLC, cancel any business licenses you had previously and obtain all the new ones as required by your new jurisdiction. (Follow all the steps in Part 5.)
2. REGISTER IN YOUR NEW STATE AND MAINTAIN YOUR REGISTER IN THE OLD STATE
If you’re relocating temporarily, you may not want to move your LLC out of your current state but may still need to register the LLC in your new state.
When you form your LLC in one state and then move to another state, most states, like California, require you to register your LLC as a “foreign corporation” in that new state.
In California, that’s done via the form LLC-5. Anytime you need to locate a form like this, start with a Google search like "register a foreign corporation in [state].” (Look for the state’s website, not a third-party site, which might charge extra.)
It’s typically simple enough to find the form, follow the instructions, and send it off.
I noted earlier that you may choose to go this route if you don't know if/when you plan to go back to your original state. My main tip in that circumstance is to check the annual fees associated with LLCs in both states. If they’re minimal, it’s not a huge burden to maintain both. If they’re expensive like California ($800 a year), you probably won't want to maintain an LLC in two states unless you’re required to do so.
3. DISSOLVE THE OLD BUSINESS AND FORM A NEW ONE
If you don’t want to be registered in both states and option 1 is a no-go, this is what you gotta do. Form your new LLC first (following the steps in Part 5 of this book). This way you don't have any gap in time with no LLC. You can find the appropriate paperwork to then dissolve your old LLC in the old state.
Without getting too into the weeds, what you actually need to do is “wind up” the LLC and transfer any assets to the members. If you’re the only owner, you're the only member. You can contribute those assets or cash to the new LLC. This is more complex than the other options. You’ll want to consult a lawyer.
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CHANGING ENTITY TYPE
What happens if you form the wrong entity? Luckily, this mistake doesn’t happen all that often. The most common way I see business owners forming the wrong entity is when they use a DIY online service and end up with C corporations.
If you’re currently operating as a “default entity” and wish to change to a “formal entity,” you don’t really need to change your entity type. Rather, form a new one (which we discuss in Part 5).
Imagine a sole proprietorship is like a really nice bag from Target. An LLC is a bag from Gucci and a corporation is a different bag from Gucci. Do you want an upgrade, in which case you’d walk into Gucci and buy what you want? Or do you need to go into Gucci to exchange that bag you bought last week because it totally doesn’t go with most of your outfits? Here, we’re talking about the exchange.
Also, remember that an S corp is not actually a type of entity. It’s a tax status. Thus, you don’t convert or change to an S corp. You elect for your LLC or C corp to be taxed as an S corp (which we also cover in Part 5).
If you have a C corp and have realized it’s probably the wrong legal structure, the options are similar to those when you need to transfer states. Option 1 is to do a conversion, if your state allows it. This allows you to file the necessary forms with your state to simply make your corporation an LLC. This is called a statutory conversion. Start by searching to see if your state allows that.
If it doesn’t, you need to form an LLC (using the steps in Part 5). Then, you can transfer your assets from the corporation to the LLC. This can be a bit complex, so I recommend hiring an attorney.
One of the more common issues recently has been folks electing S corp status too early. Typically, this happens due to bad advice from a friend—or, honestly more often, from a tax professional. Yikes. If you have an S corp and aren’t vibing with it, you can send a statement of revocation to the IRS. To learn more about the specifics just Google “how to revoke s corp status,” and the top result should be the how-to straight from the IRS website. But before taking action, consider getting a second opinion from a tax professional on whether it’s the right move, and take note that the IRS bars you from electing S corp status for some time after the revocation.
I have also had students who have formed single-member LLCs when they actually need multi-member LLCs. There are other less-common issues as well. If your legal structure requires any updates or changes not discussed here, one of the best options is to simply call your state’s secretary of state.
Generally, the person on the other end of the line is informative, helpful, and points you in the right direction. Most states have certain forms you fill out to do entity conversions. Your goal is to figure out which forms you need. As always, if the process doesn’t seem straightforward on its own, I recommend consulting a lawyer.
I WROTE A WHOLE-ASS BOOK, AND
I never thought people would be jazzed about reading a book on law in tax, but the reviews are in! And most read something like "I read this whole book, and I didn't hate it, and now I know stuff.
But for real, it walks you through my full "Unf*ck Your Biz Framework" - something I created for my first course, which was $2,000 and saw over 70 graduates - and is like the A to Z guide to get you started.
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“I never thought I would say I enjoyed reading a book on taxes, but I definitely did. Braden’s wit and spunk made this, often times, traumatic topic of taxes, actually really fun and enjoyable. He put into perspective the proper ways of filing your taxes, as well as covering if you should become an LLC, S Corp or sole proprietor, for small business owners. It was jam packed with knowledge and key tips that I have already put into effect in my own business! I’m so thankful that Braden has decided to share his knowledge and help us small business owners. Highly, highly recommend reading this book and getting your legal stuff figured out!”
- Kelsey, Owner of Kelsey Rae Designs
