Debunking the “Nevada Incorporation” Myth

Radio advertisements, even scholarly print and web-based articles, tout the notion that entrepreneurs are substantially better protected from litigation, or receive other tax and financial benefits, if their corporation is formed in Nevada rather than in California or other states. These are myths. Incorporation businesses – and even the State of Nevada itself – use mass marketing and the media to popularize the concept that there is some benefit to incorporating in Nevada. This article examines California and Nevada law to analyze and debunk the most popular myths as it applies to for-profit small businesses.

Application of California Law to Nevada Corporations
The premise of incorporating in Nevada is that Nevada law is better, and that it will apply to the corporation’s affairs. This is simply not the case for most corporations. Nevada corporations are, in most instances, governed by California law despite incorporating in Nevada. This portion of the article addresses the California laws that apply to Nevada corporations.

Foreign Corporations and “Pseudo Foreign” Corporations
A foreign corporation is any corporation other than a corporation formed under the laws of the state of California. Corp C ÚÚ167, 171. Although the laws of the state of organization generally govern the internal affairs of a foreign corporation transacting business in California, California’s Corporations Code may apply if business is conducted in California.

A foreign corporation transacting business in California is a “pseudo foreign” corporation if (Corp C Ú2115(a)):

1. the average of the property factor, the payroll factor, and the sales factor (as defined in Sections 25129, 25132, and 25134 of the Revenue and Taxation Code) with respect to it is more than 50 percent during its latest full income year; and
2. more than one-half of its outstanding voting securities are held of record by persons having addresses in this state appearing on the books of the corporation on the record date for the latest meeting of shareholders held during its latest full income year or, if no meeting was held during that year, on the last day of the latest full income year.

EXAMPLE: Demical Corporation has operations in California and Nevada. It owns $3 million in California property and $2 million in Nevada property. Its payroll is $300,000 in California and $400,000 in Nevada. Its sales are $2 million in California and $1 million in Nevada. The test applies as follows:

Property factor: The value of the company’s California property is 60 percent of the $5 million value of the company’s total property.

Payroll factor: The company’s payroll in California is 43 percent of the company’s $700,000 total payroll.

Sales factor: The company’s sales in California are 67 percent of the company’s $3-million total sales.

The total of Demical’s business factors is 170 (i.e., 60 + 43 + 67), which divided by three equals 56.67. Because the average of the business factors exceeds 50 percent, and more than 50 percent of its outstanding voting securities are held of record by persons who have California addresses, Demical is a pseudo foreign corporation.

If the corporation is a pseudo foreign corporation, California law in certain areas supersedes the law of the jurisdiction in which the corporation is incorporated (Corp C Ú2115(b)). These areas are:

• Annual election of directors (Corp C Ú301).
• Removal of and filling of director vacancies (Corp C ÚÚ303-305).
• Director’s standard of care (Corp C Ú309).
• Liability of directors for unlawful distributions (Corp C Ú316).
• Indemnification of directors, officers, and others (Corp C Ú317).
• Limitations on corporate distributions in cash or property (Corp C ÚÚ500-505).
• Liability of shareholders for unlawful distributions (Corp C Ú506).
• Annual shareholders’ meetings (Corp C Ú600).
• Shareholders’ right to cumulate votes at any election of directors (Corp C Ú708(a)-(c)).
• Supermajority vote requirement (Corp C Ú710).
• Limitations on sales of assets, merger, and reorganizations (Corp C ÚÚ1001(d), 1101,1200-1203).
• Dissenter’s rights (Corp C ÚÚ1300-1312).
• Records and reports (Corp C ÚÚ1500-1501).
• Action by the attorney general (Corp C Ú1508).
• Rights of inspection (Corp C ÚÚ1600-1605).

For companies that are entirely based in California and doing business in California, Corp C Ú2115(a) will apply, eliminating virtually all of the benefits touted by Nevada as a haven for corporate formation. As discussed below under Common Reasons Given to Incorporate in Nevada, even when Corp C Ú2115(a) is not applicable, the benefits of Nevada law are generally nonexistent or not significantly better than California law so as to justify the substantial additional cost of forming a corporation in Nevada.

Foreign Corporations Transacting Business in California

A Nevada corporation that intends to transact business in California must first qualify to do business in California as a foreign corporation by obtaining a certificate of qualification. Corp C Ú2105. Although there are certain limited “safe harbor” activities that a foreign corporation may conduct without rising to the level of “transacting business” in California, “transacting business” generally means “entering into “repeated and successive” transactions in California. Once qualified, the foreign corporation must biennially file a Statement by Foreign Corporation. Corp C Ú2117.

A foreign corporation that fails to qualify may not commence or maintain an action or proceeding in a California state court on any business transacted in California. Such a corporation may maintain an action only after it has paid a penalty of $250 and all past-due franchise taxes. Corp C Ú2203(c). Even though it may be unable to sue in California courts, the corporation is considered to consent to the jurisdiction of California courts in any civil action in which it is named as a party defendant and may defend itself. Corp C Ú2203(a).

A foreign corporation that fails to qualify may be subject to a number of sanctions, including: (1) a $20 fine for each day unauthorized intrastate business is transacted (Corp C Ú2203(a)); and (2) a misdemeanor charge punishable by a fine of $500 to $1000 (Corp C Ú2258). Agents of an unqualified foreign corporation may be subject to a misdemeanor charge punishable by a fine of $50 to $600. Corp C Ú2259.

A party to a contract with a foreign corporation that fails to qualify to do business or to file a tax return may bring a lawsuit to declare the contract void. Rev & T C ÚÚ23304.1(b), 23304.5. As a result, the foreign corporation may be precluded from enforcing its contracts. The foreign corporation must, however, be given an opportunity to cure the voidability of its contracts (i.e., file tax returns and pay all taxes). Rev & T C Ú23305.1.

Common Reasons Given To Incorporate In Nevada

The following “benefits” of incorporating in Nevada are posted on the Nevada Secretary of State website (http://sos.state.nv.us):

• No corporate income tax.
• No taxes on corporate shares.
• No franchise tax.
• No personal income tax.
• No IRS Information Sharing Agreement.
• Nominal annual fees.
• Minimal reporting and disclosure requirements.
• Stockholders are not public record.
• Stockholders, directors and officers need not live or hold meetings in Nevada, or even be U.S. citizens.
• Directors need not be stockholders.
• Officers and directors of a Nevada corporation can be protected from personal liability for lawful acts of the corporation.
• Nevada corporations may purchase, hold, sell, or transfer shares of its own stock.
• Nevada corporations may issue stock for capital, services, personal property, or real estate, including leases and options. The directors may determine the value of any of these transactions and their decision is final.

For legitimate California businesses, however, incorporating in Nevada appears to be of little value in most instances and can, in fact, increase costs of formation and annually maintaining the corporation in good standing. The following portion of this article is divided into sections that specifically address the most popular myths about incorporating in Nevada.

Nominal Fees

Nevada is widely viewed as an inexpensive state in which to incorporate, but under present law it is significantly less expensive to form a corporation in California. For example, a corporation that is formed with $100,000 of capital and does business in California would be faced with $615 in filing fees and related costs in Nevada, but the fees would only be $120 in California.

After the initial filing, the annual fees to maintain a Nevada corporation are also significantly higher than for a California corporation. To maintain a Nevada corporation doing business in California would cost approximately $1,010 annually, while maintaining the same corporation formed in California would cost approximately $810 annually.

No Corporate Income Tax

Although there is no corporate tax in Nevada, and the tax rate applicable to corporate income in California is 8.84 percent (Rev & T C Ú23151(f)(2))), California’s franchise tax is applied to the conduct of businesses in California, regardless of the jurisdiction of incorporation. Further, corporations that incorporate or qualify to do business in California are not subject to the $800 minimum franchise tax for the corporation’s first taxable year. Rev & T C Ú23153(f)(1). As a result, California is presently one of the least expensive states in which to incorporate a small business.

No Franchise Tax

California generally imposes its franchise tax on all nonfinancial corporations doing business in California, regardless of whether the corporation is a California or foreign corporation. Rev & T C Ú23151(a). California’s franchise tax on an interstate business is based on the proportion of property, payroll, and sales in California compared to the company-wide totals. Rev & T C Ú25128. If a corporation actually has the flexibility to choose to conduct business, employ personnel, or own real property in Nevada, it may be able to reduce state taxes, but the resulting reduction in tax liability would occur regardless of the jurisdiction of incorporation.

No Taxes On Corporate Shares

Nevada touts the fact it “levies no tax on corporate shares” as a benefit of incorporating in Nevada. However, California also levies no such tax. The concept apparently refers to the practice of some states (e.g., Delaware) to assess a franchise tax based on the number of authorized shares or the par value of shares.

No Personal Income Tax

Although there is no personal income tax in Nevada, this “benefit” is not useful to California residents because California residents are liable for California income tax on income worldwide, including income earned in Nevada. Rev & T C Ú17041.

No IRS Information Sharing Agreement

Nevada touts the fact that there is no “IRS Information Sharing Agreement” as one of the benefits of incorporating in Nevada. This benefit apparently appeals to those seeking privacy. However, any possible benefit to a corporation that must qualify to do business in California is eliminated by the existence of agreements that California’s tax agencies have with the IRS. See IRS Handbook 1.3, Disclosure of Official Information, Chapter 32 (Disclosure to States for Tax Administration Purposes).

The authority for disclosure of information between the IRS and state agencies is IRC Ú6103(d). IRS Handbook [1.3] 32.3. The IRS explains the purpose of disclosure (IRS Handbook [1.3] 32.1):

The exchange of confidential tax information between the IRS and the States is intended to increase tax revenues and taxpayer compliance and reduce duplicate resource expenditures.

District Directors are assigned responsibility for liaison with State tax authorities and are to be personally involved in the cooperative tax administration program.

The “basic” agreement provides for “the mutual exchange of tax data between a specific State tax agency and the Service.” IRS Handbook [1.3] 32.5, Basic Agreement. An “implementing agreement” regarding information sharing is “developed and negotiated with each State tax agency which wishes to receive Federal returns and return information on a continuing basis”. The agreement includes “tolerances and criteria for selecting those items” that will be exchanged between the agencies and the IRS. IRS Handbook [1.3] 32.6, Implementing Agreements. States that enter into such agreements with the IRS must agree to certain standards (e.g., a secure area or place in which the returns will be stored, a system to restrict access to information, etc.) to safeguard the information obtained from the IRS. IRS Handbook [1.3] 32.14, State Agency Requirements. Generally speaking, there must be a genuine interest, such as an ongoing investigation. In California, there are such agreements with the California Franchise Tax Board, Employee Development Department, State Board of Equalization, and the State Controller.

In fact, most states have reciprocity agreements in effect with the IRS and freely exchange information with federal tax authorities. States that do not enter into agreements with the IRS may still “request access to returns and return information on a case-by-case basis under IRC Ú6103(d) without entering into an Agreement on Coordination of Tax Administration.” IRS Handbook [1.3] 32.13, Disclosure to Agencies Which Have Not Entered Into Agreements on Coordination of Tax Administration.

Nevada is not willing to share tax information with the IRS and, in fact, does not participate in data exchanges. It appears that the issue in Nevada is a political one. However, without an individual or corporate income tax, Nevada may in fact be able to provide very limited information in response to IRS requests for reciprocal exchanges of tax information.

Once a Nevada company conducts business outside of the state, however, the IRS would be able to obtain any information that was disclosed to that states’ tax authorities. This brings into question how there could be any rationale that this so-called benefit could appeal to any business involved in a legitimate enterprise.

Minimal Reporting and Disclosure Requirements

Every newly organized corporation must file with the Nevada Secretary of State, on or before the first day of the second month after filing its articles of incorporation (and annually thereafter), an Annual List of Officers and Directors. The Annual List must contain: (1) the name of the corporation, and (2) the names, titles, and addresses of the officers and the directors. Nev Rev Stat Ú78.150. The reporting and disclosure requirements for California corporations are similar to those for Nevada corporations. Under Corp C Ú1502, every newly organized California corporation must file with the California Secretary of State, within 90 days after filing its articles of incorporation (and biennially thereafter) a Statement By Domestic Stock Corporation containing nearly the same information.

Privacy Concepts

As is the case in Nevada, the shareholders of a California corporation are not public record. The Statement By Domestic Stock Corporation form required in California does not identify the shareholders of the corporation.

Privacy advocates tout the benefit of “bearer” shares in Nevada. In fact, it appears that Nevada is one of the few states that allow the use of bearer shares for privacy of ownership. See Nev Rev Stat Ú104.8102(1)(b); Roberts & Pivnick, Tale of the Corporate Tape: Delaware, Nevada and Texas, 52 Baylor L Rev 45 (2000). However, bearer shares are not permitted by most states for valid reasons, including the difficulty of an issuing corporation to identify its shareholders, and the desirability of protecting shareholders from inadvertently losing valuable share ownership. One commentator notes that “[b]earer securities are common in many countries, and their absence in this country is due to the demands of tax enforcement rather than the investors’ preferences.” Davis, Pledged Stock and the Mystique of Record Ownership, 1992 Wis L Rev 997, 1061 (1992). For most small businesses, however, the most negative aspect of bearer shares is the inability to make an election to be taxed under subchapter S of the Internal Revenue Code (IRC ÚÚ1361«1379) because of limitations on the number and type of shareholders. See Forming and Operating S Corporations (Cal CEB Action Guide Spring 2002).

Qualifications of Shareholders and Directors

Nevada explains that one of the benefits of incorporating in Nevada is that stockholders, directors, and officers need not live or hold meetings in Nevada, or even be U.S. citizens. The California rule is identical. California Corp C Ú307(a)(5) provides that “[m]eetings of the board [of directors] may be held at a place within or without the state which has been designated in the notice of the meeting.” Under Nev Rev Stat Ú78.310, “[m]eetings of stockholders and directors of any corporation organized pursuant to the provisions of this chapter may be held within or without this state.” Further, there is no requirement that shareholders, directors, or officers of California corporations reside in California or be U.S. citizens. California law also does not specify qualifications necessary to serve as a director, but instead broadly authorizes the bylaws of a corporation to require certain qualifications. See Corp C Ú212(b)(4). In other words, as in Nevada, directors need not be stockholders under California law.

Liability Protection

There is no validity to the notion that shareholders are substantially better protected from litigation commenced by creditors of the corporation if the corporation is formed in Nevada rather than in California. The California rule has been stated as follows (Associated Vendors, Inc. v Oakland Meat Co. (1962) 210 CA2d 825, 837, 26 CR 806, quoting Talbot v Fresno-Pac. Corp. (1960) 181 CA2d 425, 431, 5 CR 361):

Before a corporation’s acts and obligations can be legally recognized as those of a particular person, and vice versa, it must be made to appear that the corporation is not only influenced and governed by that person, but that there is such a unity of interest and ownership that the individuality, or seauthorteness, of such person and corporation has ceased, and that the facts are such that an adherence to the fiction of the seauthorte existence of the corporation would, under the particular circumstances, sanction a fraud or promote injustice.

The California rule has two requirements: (1) that there be such unity of interest and ownership that the seauthorte personalities of the corporation and the individual no longer exist, and (2) that, if the acts are treated as those of the corporation alone, an inequitable result will follow. The California rule is narrowly applied and only applied to prevent a fraud or an injustice. In other words, it will only be applied where preserving the seauthorte distinction between shareholders and the corporation would be unjust. These authors are unaware of any reported California case where inadequate capitalization alone was deemed sufficient to warrant piercing the corporate veil, without the circumstance of avoiding unjust results.

The Nevada test is essentially the same as that applied by California courts. Both California and Nevada look at a totality of circumstances, and each state requires a finding that not piercing the corporate veil under the circumstances of the case would be to sanction a fraud or to promote injustice. See Nev Rev Stat Ú78.747(2)(c). As to liability when a plaintiff’s case involves factors sufficient to support a finding of fraud or “injustice,” the veil will just as likely be pierced applying Nevada law as it would applying California law. As stated in Rowland v Lepire (Nev 1983) 662 P2d 1332, 1337 (emphasis added):

In order to apply the alter ego doctrine, the following requirements must be met: (1) the corporation must be influenced and governed by the person asserted to be its alter ego; (2) there must be such unity of interest and ownership that one is inseauthorble from the other; and (3) the facts must be such that adherence to the fiction of a seauthorte entity would, under the circumstances, sanction a fraud or promote injustice. [Citations omitted.]

Undercapitalization, where it is clearly shown, is an important factor in determining whether the doctrine of alter ego should be applied. However, in the absence of fraud or injustice to the aggrieved party, it is not an absolute ground for disregarding a corporate entity. In any event, it is incumbent upon the one seeking to pierce the corporate veil, to show by a preponderance of the evidence, that the financial setup of the corporation is only a sham and caused an injustice.

Some non-lawyer incorporation services suggest that it is easier to pierce the veil in California because there are more California cases than Nevada cases in which the veil has been pierced. As there are more judicial decisions on virtually every topic in California, this point is not persuasive.

In sum, piercing the corporate veil law is substantially similar in both California and Nevada. Both states require a showing of substantial injustice or perpetuation of a fraud if the veil is to be pierced under the circumstances of the litigation. Hence, when choosing which state in which to incorporate, an investor should conclude that if the proposed business is legitimate and likely to be operated in a commercially reasonable manner, there is little if any benefit to incorporating in Nevada if the purpose of doing so is to decrease significantly the risk of liability for ordinary corporate obligations. Legitimate businesses conducting themselves in a commercially reasonable and responsible manner have nothing to fear by incorporating in California, and essentially nothing to gain by incorporating in Nevada.

Ability to Limit Liability of Directors and Officers

Although California Corp C Ú204(a)(10) allows the articles of incorporation of a California corporation to limit the liability of corporate directors, liability cannot be limited for: (1) intentional misconduct; (2) bad faith or breach of the duty of loyalty; (3) any transaction in which the director derived improper personal benefit; (4) reckless disregard of duty; (5) abdication of duty; (6) transactions between the corporation and the director or corporations having interrelated directors under Corp C Ú310; or (7) unlawful distributions under Corp C Ú316.

Nevada law no longer specifically provides that the articles may include a provision eliminating or limiting a director’s or officer’s liability to the corporation or its stockholders for breach of fiduciary duty. See former Nev Rev Stat Ú78.037(1). However, Nevada law now provides that directors and officers are not liable for any damages resulting from a breach of fiduciary duty unless the breach involved intentional misconduct, fraud, or a knowing violation of law. See Nev Rev Stat Ú78.138(7).

Removal of Corporate Directors

Under California Corp C Ú303(a), directors may be removed without cause by a majority of the outstanding shares (see Corp C Ú152), subject to the following limitations (if applicable): (1) Cumulative voting; (2) Class or series voting; and (3) Classified board requirement (see Corp C Ú301.5). Nevada law requires the vote of the stockholders representing two thirds of the outstanding voting power for the removal of a director. If cumulative voting is in effect, no director may be removed except on the vote of stockholders owning sufficient shares to have prevented the election in the first place. See Nev Rev Stat Ú78.335.

Nevada Corporations May Purchase, Hold, Sell or Transfer Shares of its Own Stock

California Corp C Ú510(a) provides that “when a corporation reacquires its own shares, those shares are restored to the status of authorized but unissued shares, unless the articles prohibit the reissuance thereof.” In other words, California corporations may not acquire and hold their own shares of stock.

Prior to 1977, however, this was not the case. The legislature amended the Corporations Code to eliminate the uncertainty that existed under pre-1977 law as to the legal and accounting status of “treasury shares” by eliminating the concept of such shares themselves. Under prior law, shares which had once been issued but which had been reacquired by the corporation could either be held as “treasury shares” or be retired and restored to the status of authorized but unissued shares, unless the articles of incorporation prohibited the reissuance of the shares. See Report of the Assembly Select Committee on the Revision of the Corporations Code, p 77 (1977); Ballantine & Sterling, California Corporation Laws Ú123.04 (4th ed 1962).

Nevada law corresponds to former California law. See Nev Rev Stat Ú78.283. Thus, Nevada law differs from California law in this respect.

Nevada Corporations May Issue Stock for Capital, Services, Personal Property, or Real Estate, Including Leases and Options. The Directors May Determine the Value of Any of These Transactions and Their Decision is Final.

California Corp C Ú409(a)(1) provides that shares may be issued:

For such consideration as is determined from time to time by the board, or by the shareholders if the articles so provide, consisting of any or all of the following: money paid; labor done; services actually rendered to the corporation for its benefit or in its formation or reorganization; debts or securities canceled; and tangible or intangible property actually received wither by the issuing corporation or by a wholly owned subsidiary; but neither promissory notes of the purchaser (unless adequately secured by collateral other than the shares acquired or unless permitted by Section 408) nor future services shall constitute payment or part payment for shares of the corporation.

Further, Corp C Ú409(b) provides that: “In the absence of fraud in the transaction, the judgment of the directors as to the value of the consideration for shares shall be conclusive.” Nevada law is virtually identical, except that shares can be issued for services to be performed. See Nev Rev Stat Ú78.211. The fact that stock can be issued for future services in Nevada could be material in a circumstance where one shareholder is contributing cash and the other is contributing services in return for their respective interests in the corporation.

Conclusions and Recommendations

For active, revenue producing small businesses largely based in California, the least expensive and most beneficial jurisdiction in which to incorporate is California. The widely touted “benefits” of incorporating in Nevada are generally negated by the application of California law, or in many cases are simply nonexistent.

Questions And Answers

1. It is less expensive to form a corporation in Nevada, especially if the business of the company will be conducted in California. (False)
2. Nevada law provides greater protection from liability for its shareholders, officers, and directors. (False)
3. By forming a corporation in Nevada, a business operating in California can choose to be governed by more favorable Nevada laws. (False).
4. A foreign corporation that is considered a “pseudo foreign” corporation under California law is subject to a wide range of California codes despite its state of organization. (True).
5. Corporations that incorporate or qualify to do business in California are not subject to the $800 minimum franchise tax for the corporation’s first taxable year, making California one the least expensive jurisdictions in which to form a new business. (True).
6. Neither California nor Nevada levy a tax on corporate shares. (True).
7. California residents are liable for California income tax on income worldwide, including income earned in Nevada. (True).
8. Nevada is not willing to share tax information with the IRS and, in fact, does not participate in data exchanges. (True).
9. The Shareholders of Nevada and California corporations are not a matter of public record (True).
10. A Nevada corporation that issues “bearer shares” may still make an election to be taxed under Subchapter “S” of the Internal Revenue Code (False).
11. Neither California nor Nevada law requires stockholders, directors, and officers to live or hold meetings in the jurisdiction where the corporation is formed, or even be U.S. citizens. (True).
12. California law has eliminated the concept of “treasury shares”. (True).
13. A party to a contract with a foreign corporation that fails to qualify to do business in California may bring a lawsuit to declare the contract void. (True).
14. It is obviously easier to pierce the corporate veil in California because there are more California cases than Nevada cases in which the veil has been pierced. (False).
15. Nevada is one of the few states that allow the use of bearer shares for privacy of ownership. (True).
16. Under California law, directors may be removed without cause by a majority of the outstanding shares, while Nevada law requires the vote of the stockholders representing two thirds of the outstanding voting power. (True).
17. The Nevada test for piercing the corporate veil is essentially the same as that applied by California courts. Both California and Nevada look at a totality of circumstances, and each state requires a finding that not piercing the corporate veil under the circumstances of the case would be to sanction a fraud or to promote injustice. (True).
18. Stock can be issued for future services in Nevada, but not in California (True).
19. The IRS has information sharing agreements with the California Franchise Tax Board, the Employee Development Department, the State Board of Equalization, and the State Controller (True).
20. Under Nevada law, an Annual List of Officers and Directors must be filed with the Secretary of State, identifying the names, titles, and addresses of the officers and directors of the corporation (True).

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