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The hidden cost of incorporating in Delaware or Nevada

So what is an inversion?

The flavor of the month on the avoidance versus evasion issue is the tax inversion.  The Internal Revenue Code seeks to impose income tax on profits earned abroad by American corporations.  A tax inversion is the relocation of a corporation’s headquarters to a lower-tax jurisdiction.  The material operations remain in place in its higher-tax country of origin.

Ok, so what does that mean in English?  And how does that affect you, business owner?

An inversion is a play on a basic legal concept – nexus.  Never heard of it?  Of course you haven’t because most likely you haven’t had to sit through first year civil procedure in law school.   Nexus refers to the crossing of a few things – revenue and operations, headquarters, where you are formed, where you do business, assets you own.  This cross and the tipping of the scales gives a state – or country – authority to tax you.  (As an aside, it also gives the state authorization to assert personal jurisdiction over you – see litigation FAQ).

For the small business owner and entrepreneur, this concept of nexus comes up when picking a place to incorporate or form your company.  Everyone says Delaware.  Everyone says Nevada.  Everyone says Wyoming.   Absent a special reason – either you are a public company (in which case Delaware or Nevada probably make the most sense) or need privacy for an LLC (then Wyoming’s the place) – I recommend forming in the state where you plan on doing business.  Because all of these other places have their various benefits, but they all have the same drawback – you’ll end up getting taxed twice.  You are taxed in the place where you do business and taxed in the place your business is incorporated.

That’s the magic of the inversion – by moving headquarters overseas companies are effectively shielding their foreign-sourced income from the Internal Revenue Service and the American corporate tax system.

And like all other loopholes, this too shall close.



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