Where your business is located does not have to dictate where the business is incorporated. In fact, you might be better off choosing to incorporate in a state thousands of miles from your home office. Choosing where to incorporate is not a matter of ease of distance but, rather, ease of business.
Corporations do not receive equal treatment across the country. Every state sets its own business laws and regulations. Some states are considered business-friendly. Others, like California, are almost anti-business. A decision as simple as where your business is incorporated can make a big difference to your bottom line and your peace of mind.
Nevada, Wyoming and Delaware are states which offer a favorable corporate law and low taxes. Nevada and Wyoming have no corporate or personal income tax. Delaware taxes entities doing business inside their state. But by setting up in those states you have the benefit of a favorable corporate law without the need to pay extra taxes.
Conversely, suppose you set up a California corporation to do business in Oregon. Not only would you have to pay Oregon taxes (because you are doing business there) but you would also have to pay California’s notorious $800 per year franchise fee because you incorporated there. You won’t set up in a high tax state to do business in another state.
What if you set up a Nevada corporation for your plumbing business in Ohio? Because you are doing business in Ohio you will submit the Nevada paperwork to the Ohio Secretary of State’s office and ‘qualify’ to do business in Ohio. You will pay Ohio state taxes on your business profits. But because Nevada has no corporate tax you won’t pay any extra money in taxes by setting up in Nevada. (You will, however, have to pay Nevada’s annual fee and a registered agent fee in Nevada.)
Choosing which state to incorporate in is an important decision and may turn on what type of business you have, what your financial goals are and what the laws of your home state are compared to those of a favorable state. Be sure to consult with your professional team so that you understand all the pros and cons before you commit. As well, there is more information on these issues in Start Your Own Corporation.
Now let’s review our third case...
Case 3: Bobo and Morton
Bobo and Morton had attended prep schools from kindergarten through high school together. Morton’s full name was Morton Winthrop Trentham III. Bobo’s full name was Anstergard VanDyke McGill, but because as a very young child he made quite a scene on the Bobo the Clown local afternoon TV show, everyone called him Bobo.
The two boys came from very wealthy families. Their great-great-whatever-grandfathers had been tycoons during the Gilded Age of the 1880’s. The Trenthams and McGills had also been the original founders of The Thracian Club, a very posh country club offering golf, equestrian and yachting activities. Many well-heeled and accomplished people were members, most prominently a number of sophisticated Wall Street money managers, including financial wizard Frank Fodom. Many people wanted to get into The Thracian Club, or ‘The Club’ as members called it. Not everyone did. The list was long and the criteria rigid or, as some would say, snooty.
Bobo and Morton had no such acceptance worries. Because the two were direct descendants of the founders, they were automatic members of The Club. Yet their family members knew that Bobo and Morton would never get in on their own merits.
Morton was short and spindly while Bobo was barrel chested and hefty. Together they resembled the famous comedy team of Laurel and Hardy. The comparison did not end there.
Unlike virtually all of their prep school friends, Bobo and Morton did not go on to expensive colleges. Neither of them did well in school nor did they have any interest in prolonging the pain. While their parents were well-connected and well-funded, that was not enough to guarantee a career for the two boys. And so as their other children moved on, both sets of parents knew they would have to come up with something for the boys to do.
The Trentham family had a large dog kennel on their very large property. The boys both liked dogs. The idea arose that Bobo and Morton should run a dog breeding business. Both families liked the whippet breed, which the American Kennel Club describes as “a medium size sight hound giving the appearance of elegance and fitness, denoting great speed, power and balance without coarseness.” It was the perfect breed for the Trenthams and McGills. All Bobo and Morton knew was that these slightly built canines were miniature greyhounds that could run up to 35 miles per hour.
The Trenthams and McGills put together a business and funded a bank account. The boys received a small salary. They acquired six whippets for breeding and started to pay for feed, equipment, veterinarians and the like.
The breeding business was not lucrative. In fact, it brought in just one sale, and plenty of annual losses. The whippets did not respond to Bobo and Morton’s unfocused, unscientific breeding attempts. When a friend said he used the soulful music of Barry White to set the mood, the boys tried that with the whippets. When Barry White didn’t work they went on to the next half-hearted attempt at breeding.
Whenever they got the chance, the dogs would run away. While there was no way chunky Bobo could ever catch them, neither could spry Morton. The whippets were born to run, and run they did.
As dogs disappeared, their parents, somewhat strangely, and without question, approved the purchase of more whippets. This went on for over two years until two very dramatic things happened.
First, the County Sheriff, John Law, showed up at the kennel with a complaint. The runaway whippets were doing something they never did for Bobo and Morton-they were breeding. There was now a large pack of wild whippets roaming the county. They were knocking over garbage cans and cruelly taunting the authorities with their speed. Sheriff Law made it clear, in a very loud and angry voice, that he did not like to be cruelly taunted. He inquired where their dog breeding, health permit and city business licenses were located. When Bobo said he didn’t know if they had any of that, Sheriff Law handed him an order to shut down the kennel. He departed in an official huff leaving the main gate ajar. Before Sheriff Law took five steps to his black and white patrol car, six whippets were out the gate and sprinting off into the countryside.
That same day, the boys’ parents received a certified letter from the IRS. They were being audited on the dog breeding business. Because the parents had been writing off significant losses (and receiving a tax break for the losses) while no real income had been generated, they were subject to hobby loss rules.
The parents brought in their attorneys and CPAs to deal with the sheriff and the IRS. There were fines and penalties to pay on both fronts. One of the CPA’s assistants who knew Bobo and Morton found the whole situation hilarious. He dubbed them the ‘Hobby Loss Twins’ which, to Bobo and Morton’s chagrin and anger, made the rounds around town.
And with their dog breeding business suddenly shut down, Bobo and Morton needed to find something new to do...
Hobby Loss Rules
When getting into business you must distinguish between a legitimate business and an activity that is considered a hobby or a business that is not at all profitable. The IRS has been targeting hobby losses for many years. Losses from hobbies cannot be written off against other income. Look at it from the IRS point of view. If you love breeding horses, and make no money at it, why should you get a write off? If your new business makes a profit, then you don’t have to worry about the hobby loss rules. On the other hand, if the new enterprise consistently generates losses (deductions exceed income), the IRS may step in and say it’s a hobby rather than a business.
There are two ways to avoid the hobby loss rules. The first way is to show a profit in at least three out of five consecutive years (two out of seven years for breeding, training, showing, or racing horses). The second way is to run the venture in such a way as to show that you intend to make it profitable. The IRS regulations say the hobby loss rules won’t apply if the facts and circumstances show that you have a profit-making objective.
How can you prove that your objective