Nevada Fallacy of an LLC (or Delaware or Wyoming!)

Should you form your LLC in Nevada, Wyoming or Delaware to avoid state taxes? You might have heard that you can. Sure, if tax fraud comes easy to you. Sorry Charlie, it does not work that way, for two reasons.

First, and this is the one that sinks most small business owners, if your home state imposes an individual income tax, it generally taxes its residents on all their income, wherever it comes from. If you live in Colorado and your LLC’s profit flows to your individual tax return, whether the LLC is a disregarded entity, a partnership or an S Corp, that profit lands on your Colorado tax return whether the LLC was formed in Colorado, Nevada or on the moon. Forming the LLC elsewhere just adds a second state’s fees to the bill.

Second, the business’s income gets apportioned among the states where the business operates or has customers, not simply the state where it was formed. People use “allocated,” “assigned” and “apportioned” interchangeably all the time, including plenty of accountants, but technically they mean different things. Apportionment generally divides business income among states using a formula, while allocation assigns certain items of income to one particular state. Yay, words. For our simple example, we are talking about apportionment.

How State Apportionment Works

The classic three-factor formula looked at payroll, property and sales, often giving each factor equal weight-

• Payroll. One third of the apportionment formula is based on payroll. If you have payroll only in Colorado and California but formed your LLC in Nevada, the payroll factor looks to Colorado and California, after applying California’s crazy rules. Nothing goes to Nevada.
• Property. The second third of the formula is based on where your property sits, such as real estate, equipment and inventory.
• Sales. The last third of the formula is based on where your sales occur, which can get extremely sticky. Is a sale where the seller is, where the buyer is, where title transfers, or where the fulfillment center ships from? States and taxpayers can go around and around on this, and you can only imagine how it ends fighting a state with virtually unlimited resources and time, coupled with its presumption of being right.

Today most states weight sales much more heavily, and many, including California, use sales alone (a single sales factor). For services, many states now source the sale to where your customer receives the benefit. Translation: if your customers are in California, California wants its slice, no matter where your desk is.

Could some receipts or business income legitimately end up in Nevada? Sure, if the facts and the applicable sourcing rules put them there. But that has nothing to do with filing your Articles of Organization in Nevada. You need actual business facts that point to Nevada. And “no income tax” does not mean “no tax.” Texas has its franchise (margin) tax, Washington has its business and occupation (B&O) tax, and Nevada has its Commerce Tax on larger businesses. These states can still tax businesses using things such as margin or gross receipts rather than a traditional tax on net income. There are other gotcha states as well.

Note: This is a super simple sample. Talk to your apportionment buddies at WCG CPAs & Advisors. As gray tax positions go, income apportionment is right up there with the best of the “well, it depends” accountant responses. See wcginc.com/state for exhilarating information.

State Nexus

Before we apportion anything, another question comes first: nexus. Nexus asks whether a state has enough connection to tax you at all. Apportionment asks how much of your business income belongs to that state. Related concepts, but not the same thing.

States are getting much more aggressive with claiming nexus so the income generated in their state is taxable. This might make people unhappy, but the reasoning behind it is fair in our opinion. Say you target customers who live in a certain state, and you sell computers. Why would Best Buy in that same state have to pay income taxes there while you do not? Please don’t use the “it’s just little ol’ me versus the big box store” excuse. Seems a bit unfair if you are Best Buy, or Walmart, or Apple. Go and compete, just make it a level playing field. If you can’t compete fairly, then find something else to do.

Additionally, those customers perhaps enjoy a lower tax rate and more purchasing power, and that might be offset by higher taxes on the businesses that serve them. Business A (Best Buy) subsidizes the customers in that state while Business B (you) does not. Best Buy would be a bit upset.

Stepping down from the soapbox, avoiding taxes is the American way. We get it. But something about equal protection under the 14th Amendment comes to mind, and the pursuit of happiness (technically the Declaration of Independence, but you get the idea). Then there’s that darn 16th Amendment.

States define economic presence differently-

• Bright-line thresholds. A growing number of states, California among them, treat you as doing business once your sales, property or payroll in the state cross a dollar threshold, even with no office or employees there.
• Presence. If you have an agent or employee working for you in a state, you likely have income tax nexus there.
• The basics. Bank accounts, licenses, permits and other state contacts can matter too, depending on the state and the particular tax involved. If you must be licensed in another state to legally conduct business, such as an insurance agent, that alone might create nexus.

Sellers of tangible goods get one narrow federal shield. Public Law 86-272 can prevent a state from imposing a net income tax when the business’s only in-state activity is soliciting orders for tangible personal property that are approved and shipped from outside the state. It does not protect service businesses, and it does not exempt anyone from sales taxes, gross receipts taxes or every other state tax. States have also taken increasingly narrow views of the protection when internet activity goes beyond solicitation, so do not lean on it too hard.

Remember, even when a state has the right to tax your business, the next question is how much income is sourced or apportioned there. Can’t get enough? Here is a Journal of Accountancy article from 2010 (yeah, it’s a little old but so are most accountants, and it provides a good base to learn from)-

wcginc.com/1515

This book dives deeper into nexus in a later chapter, with topics such as sales tax, FBA (Fulfillment By Amazon), throwback rules and interstate commerce rules. Since the South Dakota v. Wayfair U.S. Supreme Court decision in 2018, every state with a statewide sales tax has adopted economic nexus rules, often, but not always, using a sales threshold around $100,000.

Massive Word of Caution: You might not have noticed, but we just introduced two nexus issues side by side, income tax nexus and sales tax nexus. These are wholly different! Having income tax nexus in a state does not mean you have sales tax nexus there, and vice versa. People muddy the waters by interchanging the two, just like 401k and IRA. Don’t.

Foreign Qualification

This has nothing to do with international business. If an LLC or corporation formed in one state conducts enough business in another state, it might have to register there as a foreign entity.

Here is another terminology mess. “Doing business” does not have one universal definition. A business can be doing enough in a state to create tax nexus, enough to be sued there, or enough to require registration as a foreign entity, and those are three different tests. Same phrase, three different questions. Neat.

Do not confuse foreign qualification with tax nexus. They are cousins, not twins. You can have enough economic nexus to owe taxes or file a tax return in a state without necessarily having to register your entity with that state’s Secretary of State. In fact, many states specifically list activities that do not, by themselves, require foreign qualification-

• Maintaining a bank account
• Selling through independent contractors
• Conducting isolated transactions
• Engaging solely in interstate commerce

The exact rules vary by state, so this is another one of those wonderful “it depends” moments. If foreign qualification is required, the state will commonly want proof that your entity remains in good standing with its home, or domicile, state. Therefore, keep up with your annual filings with the Secretary of State.

Here is where theory meets reality. If you have a remote employee in another state, or you personally perform services there (think traveling nurse, locum tenens physician or CRNA), your business will typically need withholding and unemployment accounts in that state for payroll processing. Many states now link those agencies together, so the department of revenue or labor wants to see your foreign registration with the Secretary of State before it will issue payroll accounts. So even when the tax and foreign qualification tests are technically separate, payroll registration can make foreign qualification the practical answer. The remote employee is one of the most common ways small businesses end up registered in states they never planned on. Yeah, yuck.

Foreign qualification is not just administrative housekeeping, either. Failing to register when required can trigger penalties and, in many states, keep your business from using the state’s courts until you clean things up.

Conversely, you might decide to create a separate LLC in the satellite state rather than have the original entity conduct the local activity. A properly structured and respected separate entity can help segregate liabilities, but this is a legal structuring question and should be reviewed with competent counsel. A second LLC does not create magical liability isolation any more than the first one did.

Nevada Fallacy Recap

So, don’t believe the Nevada hype. Some people try to skip state income taxes on their own, but as tax and accounting professionals we are bound by such inconveniences as ethics and law. Sorry.

The lesson of this whole section fits in one line: formation state, tax nexus, sourcing, apportionment and foreign qualification are separate questions.

The bottom line is that Nevada tax laws benefit business owners with an actual presence in Nevada. You might get a free lunch for a while, but eventually you’ll have to pay. We encourage you not to game the system, and if you want to, WCG cannot be a part of it; we have too many clients relying on us to do the right thing. But it does sound like it could be a good time. Kidding aside, please pay your fair share of taxes, just not a dollar more.

Having said that, there are plenty of good reasons why forming a corporation or an LLC in a particular state does make sense, such as Delaware for venture capital or Wyoming for privacy. But those are case-by-case scenarios. Nothing is a slam dunk or carte blanche either way. The right questions must be asked and answered to reach the best decision.

Sidebar: Washington, D.C. Plays by Its Own Rules

Here is some more gee whiz fodder. You have a home office in Maryland and commute to D.C. to work for your only client. You form your corporation in Maryland and pay yourself a wage subject to Maryland income taxes. Simple, right? Not quite. Your business activity in D.C. can require the corporation to file a D.C. corporate franchise tax return, while foreign qualification is a separate question. Better yet, D.C. does not recognize the S Corp election for its corporate franchise tax, so it taxes your corporation like a C Corp.

Congress bars D.C. from taxing the wages of nonresidents, so your paycheck remains Maryland’s problem. The corporation, however, is a different story. One commute, two jurisdictions, more tax returns than you wanted.

Who knew? We can help navigate.