By Jennifer Friedman
As a small business grows, many owners may reach the point when it makes sense to expand business operations into a new state. Determining when and how to do this can often be confusing, but an understanding of what this process entails can alleviate concerns and allow a small business to successfully navigate this exciting time of growth and expansion.
Every state requires that any company that does business within its borders be officially “on record” with the state. Different states have different criteria, but that means if your company accepts orders, or has a physical presence, or employees in a given state, you will likely need to file with that state. A business has two options for meeting this requirement: foreign qualification, or incorporation or formation of a new LLC in that state.
Foreign qualification, not to be confused with doing business outside of the US, simply refers to a business operating outside the state in which it was incorporated. This is the most common and least burdensome method for doing business in another state. To foreign qualify a business, owners must register for a Certificate of Authority in the state(s) in which their company will do business and pay required state fees.
An alternative to foreign qualifying is to incorporate or form a new LLC in other states in which you plan to do business. This can make sense for certain types of business operations and under certain circumstances. How do you know which route to embark on? The main difference is that when a business incorporates in multiple states, the company becomes domestic in each of those states, thereby creating separate entities. However, having separate business entities has its own implications.
Consider the following four factors in making your decision:
- Corporate formalities. When creating new corporations in additional states, there is an increase in corporate formalities, such as drafting and maintaining bylaws; issuing stock and recording all stock transfers; holding initial and annual meetings of directors and shareholders; and keeping minutes of all director and shareholder meetings with the corporate records. These added responsibilities can be a large disadvantage, as well as extremely time consuming. LLCs do have the same complicated formalities imposed on corporations.
- Separate owners and management. When creating a separate corporation in each state, each business has its own stock, shareholders, directors and officers. Even if the management remains consistent, the formalities apply for each domestic corporation, greatly increasing the annual record-keeping requirements.
- One company or many. Foreign qualification means only one corporation or LLC exists. Therefore, corporations, regardless of the number of states in which it foreign qualifies, only needs one set of bylaws, stock, shareholders, directors and officers. This also means that record keeping for initial and annual meetings of directors and shareholders happens just once. For tax purposes, the new company will need to have a new federal tax employer identification number (EIN) and will need to file a separate tax return, unless it is formed as a subsidiary. Advice from a tax professional is recommended to structure the companies most effectively.
- Liability separation. Creating a new corporation or LLC in each state creates liability separation. If a company is forced into bankruptcy in one state, assets of the company in the other states are normally not used to pay for the bankruptcy. With foreign qualification in multiple states, there is no separation of liabilities, as only one corporation or LLC exists. This can be a significant advantage for certain high-risk undertakings and can outweigh the negatives associated with creating an entirely distinct company.
Carefully weighing the pros and cons of foreign qualification vs. incorporating in each state is important, and small businesses should work to closely align their ultimate decision with long-term business goals. Expanding a business’ operations into new states is a significant milestone for any small business owner and an exciting time for a growing company. Whether choosing to pursue one path or the other to expand a business across state lines, remaining aware of the implications and duties that follow will ensure small businesses comply with regulations and fee requirements, while meeting standards to stimulate successful growth.
Jennifer Friedman is the CMO of the Small Business segment of CT, providing legal compliance solutions to the small-business community.