Forming the Entity in Another State

When choosing the state in which to form a business entity, the small business owner can pick any state and he or she needn't conduct any business activities there. But in whichever state you choose, articles of organization need to be filed with the appropriate state agency, including the name of a resident agent for service of process (i.e., for purposes of consenting to the state's jurisdiction).

The articles are usually filed with the corporations division of the secretary of state's office. A fee is required at the time of the filing. Failure to file means the entity does not exist, and the owner is operating a sole proprietorship or a general partnership (see our discussion of formation issues).

In addition, the entity must register as a "foreign" entity in each other state in which it does any substantial business. The activities of a holding entity usually would not rise to the level of "doing business" in a state. Thus, normally, an out-of-state holding entity would not have to register in either the owner's home state or where the operating entity conducts the business's operations.

Failure to register in this regard should be distinguished from failure to file articles of organization. The consequences of a failure to register as a foreign entity in a state vary from state to state. For example, the entity may be barred from pursuing legal or equitable relief in state courts. On the other hand, failure to register will not prevent others from bringing legal actions against the corporation. Some states impose civil penalties for failure to register. And, some states simply provide that the entity must pay the registration fee that was due.

However, a few states might provide for far more insidious results, by not recognizing the entity, which would result in unlimited personal liability for the business's debts incurred in that state, or invalidation of the business's contracts. When in doubt, register--or consult an attorney for advice.

Note that the entity-within-an-entity concept, which is embodied in the Delaware limited liability company (LLC) statute, eliminates this problem. A single LLC can house multiple separate legal entities. This single LLC is formed in Delaware, and then registers in any state in which the operating entities will do business.

California prevents professionals from operating in the LLC form. California also limits its limited liability partnerships (LLPs) to a narrow class of professionals, namely lawyers, architects and accountants. New York also limits LLPs to professionals, but defines this term more broadly than California. A business entity's internal matters (voting, management, etc) and liability status will be governed by the state in which it is formed. However, nothing requires a state to recognize a type of entity that cannot be legally formed there. Thus, in the case of professionals who form an LLC or an LLP, and plan on doing business in California or New York, caution must be exercised. If the entity could not be formed in those states, it also will not be recognized if it is formed in another state, and then seeks to register to do business in those states. The end result could be that the business will be recognized, under those circumstances, only as a sole proprietorship or general partnership.

There are other aspects to consider when forming an entity outside of the owner's home state, such as fee considerations and the differences among state laws, as well as the advantages and disadvantages that result from these differences.