The purpose of this article is for those who feel the California LLC Annual Franchise Tax of $800 per year is too high, and instead, they are wondering if they should form an LLC in another state instead of starting a California LLC.
If you live and work in California, and you form an LLC in another state, you are required to register that out-of-state LLC as a Foreign LLC in California. This creates 2 LLC filing fees, a Registered Agent in the foreign state, annual reports in both states, and possible state and local tax obligations in the foreign state (and in CA, of course).
So this begs the question, what does it mean to “do business in California?”
What Constitutes Transacting/Doing Business in California?
The rules of “doing business” vary by state, however, there is one national rule of thumb which most courts will use. A company is “doing business” if a substantial part of its ordinary business is transacted there.
So what defines a “substantial part of ordinary business”?
Of course, this is open to interpretation, but let’s look at a common example to paint some context.
Who: Dave is a 32 year-old US citizen who lives in San Diego, California.
What: Dave is currently a sales consultant. Most of his clients are in California, but he also has a lot of clients across the US. He wants to form an LLC and expand his business. He is planning on doing a lot of business through the internet, creating and selling online courses.
His Thinking: Because Dave is working with clients all over the US, and soon-to-be, all over the world, he is thinking he’s “doing business everywhere”, and therefore, he can form an LLC outside of California to escape the $800 per year LLC Annual Franchise Tax.
Think of it like this: even if Dave formed an LLC in, say Delaware, but he is a resident of California, he already pays state and local taxes in California, primarily works from home in California (or within state borders), makes phone calls from California, accepts contracts while in California, and keeps files stored in his home office (physically or digitally) in California, then it sounds like he’s doing business in California.
Just because Dave is doing business online (who doesn’t these days?), it’s not enough. I’d say, it’s best for Dave to play his cards clean from the start.
What’s the point of forming an LLC in another state just to save $800/year, if it could eventually cost him a lot more (and expose his to risk)?
Sure, the “LLC police” aren’t going to be knocking on Dave’s door next week to check up on him, but there are compliance departments within the California Secretary of State and the Franchise Tax Board, and eventually, he’s bound to get caught and fined.
Further, there are risks to doing business as an unqualified entity in CA:
1. Denied access to California courts (inability to enforce a contract, as an example).
2. Required to file/pay taxes, as well as penalties and fines.
3. Grayness in the law about the ability to bring a counterclaim.
4. Personal liability may arise if you are acting on behalf of an unauthorized entity. While some states have statutes more open to interpretation, California has clearly defined statutes that impose fines on individuals acting for noncomplying foreign entities.
As for the details on what constitutes “transacting business” in California, here is more info:
“Before transacting intrastate business in California the business must first qualify/register with the California Secretary of State. (California Corporations Code section 2105, 15909.02, 16959 or 17708.02) California Corporations Code sections 191, 15901.02(ai) and 17708.03 define “transacting intrastate “as entering into repeated and successive transactions of its business in this state, other than interstate or foreign commerce.”
Rather than spend time, energy and money on dodging California’s annual franchise tax fee (which exposes Dave to fines, taxes, and worse, liability), I recommend he instead focus on business growth, product development, marketing, sales, etc.
I like to think of the $800/year as the cost of doing business in CA ;) And unfortunately, I don’t see (nor recommend) any way around it.