Introduction to Delaware PIC Strategy
Before establishing a corporation, the founders must make key decisions that will impact the articles of incorporation and the state in which they incorporate. Delaware is often seen as the best state for corporations, especially if they are public or plan to go public in the near future. Delaware has favorable laws and a judicial system that is well-versed in corporate and securities matters. However, for private companies with no plans to go public, Delaware may not be the most favorable option, as it has higher taxes compared to other states. Some states, like Nevada, Ohio, Texas, and Washington, have a gross receipts tax instead of a corporate income tax, which can be lower than the corporate income tax in Delaware. Additionally, Delaware’s franchise taxes can be as high as $180,000 per year, whereas many other states have much lower maximum franchise taxes.
Delaware is often used as a tax haven for specific income-generating assets through a strategy known as a Passive Investment Company (PIC) or Delaware Holding Company. This strategy involves transferring income to Delaware from high-tax states, which converts taxable income into tax-exempt income and reduces taxes through regulatory arbitrage.
The Delaware PIC tax strategy involves setting up a Delaware subsidiary (the PIC) and transferring ownership of intangible assets to it. The operating subsidiary located in a high-tax state then pays a royalty to the Delaware subsidiary for use of the intangible asset, which is deductible in the high-tax state and exempt from taxation in Delaware, leading to a situation where the company doesn’t pay tax to any state on the income shifted to the PIC. The more valuable the intangible assets, the higher the royalty payments and the greater the tax savings. This strategy takes advantage of Delaware’s definition of intangible assets, which is broad, to generate tax benefits.
To take advantage of the Delaware PIC tax strategy, a company not only needs intangible assets owned by a Delaware subsidiary, but it must also operate in states with tax laws that support the strategy. Previously, some states, known as “separate filing” states, only required entities with a physical presence in the state to file and pay taxes. Therefore, a Delaware PIC had no tax obligation in such states because it did not have a physical presence there.
States have taken measures to reduce the tax revenue loss associated with the Delaware PIC strategy. Two of the most successful methods employed by states are combined reporting and the economic nexus doctrine. Combined reporting requires a company to include the profits of all its domestic entities in a combined tax return, eliminating intra-company transfers that make the Delaware PIC strategy possible. The economic nexus doctrine allows states to tax income earned by corporations with significant economic activity in the state, regardless of whether the firm has a physical presence. This doctrine would apply to the royalty income that escapes taxation in Delaware and would limit or eliminate the tax benefits of the Delaware PIC strategy if enforceable.
Other Popular Domicile States
Delaware is the preferred state of incorporation for large and mid-sized public companies due to its favorable court system, progressive business and securities laws, and the perception of being a premier state for public and soon-to-be public companies. Meanwhile, small public companies tend to incorporate in Nevada for its minimum public disclosures, low cost, and relaxed shareholder meeting requirements. However, Nevada is often perceived as a domicile for small companies or as a haven for companies fleeing California’s regulations and taxes.
In summary, the choice of a domicile state for a company depends on various factors such as size, public vs. private, industry, potential for growth, and financial, legal, and regulatory considerations. Delaware is often favored by large and mid-sized public companies due to its favorable court system and business-friendly laws, while Nevada is preferred by small public companies due to its low cost and minimum disclosures. On the other hand, states like Texas, Utah, and Virginia often rank high in “best states for business” surveys, while California and New York are not favored due to their regulatory and tax systems. For private companies, the state in which the business is located may be the appropriate choice, as incorporating in Delaware may not provide benefits that offset the costs. Companies in specific industries may also prefer certain states, such as Maryland and Massachusetts for real estate development companies.
Frequently Asked Questions
What is the Delaware PIC strategy?
The Delaware PIC strategy is a tax avoidance strategy that allows companies to take advantage of the fact that Delaware has low taxes on intangible assets, such as patents and trademarks, by creating a subsidiary in Delaware to hold these assets.
Why is Delaware attractive for the PIC strategy?
Delaware is attractive for the PIC strategy because it has low taxes on intangible assets and has a favorable legal system for businesses.
What are separate filing states?
Separate filing states are states that only require companies to file and pay taxes if they have a physical presence, or nexus, in the state.
What is combined reporting?
Combined reporting is a method used by some states to counteract the PIC strategy by requiring companies to include the net profits of all their domestic entities in a consolidated tax return, effectively eliminating intra-company transfers that make the Delaware PIC possible.
What is an economic nexus doctrine?
An economic nexus doctrine is a method used by some states to claim the right to tax income earned by corporations with a sufficient economic footprint in the state, regardless of whether the firm has a physical presence in the state.
Why do some companies choose Nevada as the state of incorporation?
Small public companies often choose Nevada as the state of incorporation due to its minimum public disclosures and filing requirements, relative low cost as a domicile state, and attractive location for annual shareholder meetings.
Why do large and mid-sized public companies choose Delaware?
Large and mid-sized public companies choose Delaware due to its court system, progressive legislature in terms of business and securities laws, and reputation as the premier domicile state for public and soon-to-be public companies.
What are the best states for business according to surveys?
According to surveys, Virginia and Utah often rank at the top of “best states for business,” while Texas has recently also been a top state.
What is the recommended state for incorporation for a private company?
If the company is a private company with small potential revenues and no plans for becoming a public company, the state in which the business is located is often the appropriate state for incorporation.
What are some states with appealing laws for specific industries?
Some states, such as Maryland and Massachusetts, have laws that are appealing to companies in specific industries, such as the real estate development industry.
What is the process of incorporating a company?
The process of incorporating a company involves selecting a state of incorporation, filing articles of incorporation with the state, obtaining any necessary licenses and permits, obtaining a tax ID number, and potentially registering to do business in other states if the company has operations there. It also involves drafting bylaws and holding an organizational meeting. The exact process may vary by state.
What are the benefits of incorporating a company?
Incorporating a company provides limited liability protection to owners, also known as shareholders, allowing them to separate their personal assets from the company’s assets. Incorporating also makes it easier to raise capital and attract investors. Additionally, a corporation has a potentially longer lifespan than a sole proprietorship or partnership, and can provide more structure and stability for a business.
What is the difference between a C corporation and an S corporation?
A C corporation is the standard corporation structure that is taxed as a separate entity from its owners. An S corporation, on the other hand, is a type of corporation that meets certain requirements and as a result, is taxed as a pass-through entity, with the company’s income and losses being passed through to the owners and reported on their individual tax returns.
What is the impact of state of incorporation on taxes?
The state of incorporation can have a significant impact on a company’s tax liability. Some states, such as Delaware, have tax laws that are more favorable to corporations, while others have laws that are less favorable. It’s important to consider the potential tax implications when choosing a state of incorporation.
What are some factors to consider when choosing a state to incorporate in?
- Business climate and state taxes
- Industry-specific laws and regulations
- Litigation costs and the state’s court system
- Public disclosures and filing requirements
- Perception and reputation of the state as a domicile for businesses
- Size and potential of the company (e.g. large public companies may prefer Delaware while small private companies may opt to incorporate in the state they operate in)
- Personal preference and convenience (e.g. location of annual shareholder meetings)
Why is Delaware often considered the premier domicile state for public and soon-to-be public companies?
Delaware has a well-established court system, progressive legislation in terms of business and securities laws, and a reputation among public investors and Wall Street as the premier domicile state. Additionally, many major public corporations are incorporated in Delaware, making it a common choice for companies.
Why might a private company choose a state other than Delaware for incorporation?
Small private companies located outside of Delaware may not realize the benefits of incorporating in Delaware and may pay more in annual state fees or franchise taxes. State laws can also be appealing to companies in certain industries, such as real estate development, which may favor states like Maryland or Massachusetts due to favorable real estate industry laws.
What are some states commonly considered to be business-friendly and a good choice for incorporation?
States commonly considered to be business-friendly and a good choice for incorporation include Texas, Virginia, and Utah, which often rank high in “best states for business” surveys based on factors such as financial stability, favorable business laws, and a pro-business climate.