One of the popular entrepreneurial myths, at least in some circles, concerns incorporating in Nevada.
The story goes something like this: While you’re working and running your business in a high-tax state like, say, California and getting just killed on your state income taxes, some of your smarter buddies and more clever competitors have located an escape hatch–Nevada. Specifically, these guys have incorporated their businesses in next-door Nevada and thus avoid California income and franchise taxes.
The obvious question is, “is incorporation in another state something you can do to reduce your state tax burden”?
To best answer this question, I’m going to explain what usually happens if you incorporate a business located in, say, California or Arizona, in Nevada. After that, I’m going to how you actually truly save state income taxes by using out-of-state incorporation.
How Nevada Incorporation Usually Works
Let’s say, for starters, that you have a California consulting business with three employees (you and two able assistants) and three laptops. The business makes profit, just for illustration’s sake, equal to $400,000 providing services in California.
Summing up, then, all of the services get performed in California, all three employees live and work in California, and the only assets of the business (those three laptops) are located in California.
So, what happens with Nevada corporation in this case?
Well, for starters, note that because you’re operating in California, your Nevada corporation will need to register with the California secretary of state as a foreign corporation. And you’ll need to pay any franchise taxes due–just like a regular domestic, or in-state, corporation would.
At the end of the year, California, like most other states, will require you to use an apportionment formula to determine what share of your profit is subject to tax in California. California’s apportionment formula requires you to allocate 50% of your profit based on sales, 25% based on payroll, and 25% based on property.
It’s sort of tedious, but let me walk you through these calculations because understanding the arithmetic lets you understand why Nevada incorporation usually doesn’t work–and when it might work.
In the case of the profit allocation that’s performed based on sales, you first calculate the 50% of the profit that will be allocated based on sales. 50% of $400,000 equals $200,000. Accordingly, $200,000 of the profit will be apportioned to states based on where the sales occur. In the case where you’re talking about services, by the way, the “sales” occur where the service is provided. Accordingly, if all of the services are actually performed in California, all of the $200,000 “sales” chunk of the profit gets apportioned to California.
The math works the same for the payroll and property apportionments, too.
For payroll, you calculate the 25% of the profit that will be allocated based on payroll. That equals $100,000 because 25% of $400,000 equals $100,000. This $100,000 chunk gets apportioned to states based on where the payroll occurs. In the case where you employ three people and they all work and live in California, the $100,000 “payroll” chunk of the profit also gets apportioned to California.
For property, the same painful accounting occurs. You calculate the 25% of the profit that will be allocated based on property. That equals $100,000 because 25% of $400,000 equals $100,000. This $100,000 chunk gets apportioned to states based on property owned within a state. In the case where your only property consists of three laptops used in California, bingo, the $100,000 “property” chunk of the profit also gets apportioned to California.
Summing up, the apportionment formula used by California mechanically assigns corporate profit based on sales, payroll and property. And a business that really only operates in California can’t avoid taxes by incorporating in Nevada and then registering as a foreign corporation in Nevada.
Making Nevada Incorporation Truly Work
If you understand the apportionment formula, you can see that there is a way to incorporate in Nevada and save California taxes.
For example, what if employees have to buy their own laptops but they use a server that’s located in Nevada. In this case, there’s not property in California and there is property in Nevada–which means that the $100,000 “property” chunk of profit gets apportioned all to Nevada. This obviously cuts the California state tax bill by 25%.
Similarly, what if rather than hiring California residents as employees, you hire two Nevada residents as employees. You might be able to do this if your employees telecommute or work out of their homes. In this case, the services that your consulting business provides are performed two-thirds by the two Nevada employees, you would allocate two-thirds of the $200,000 “sales” chunk of profits to Nevada, or $133,334. And you would allocate one-third of the $200,000 “sales” chunk of profits to California, or $66,666.
To make the math easy, let’s assume that all three employees get paid the same amount, too. That would mean that, just like the sales apportionment, that two-thirds of the $100,000 “payroll” chunk would be allocated to Nevada–that would be $66,667. And one-third of the $100,000 “payroll” chunk would be allocated to California–that would be $33,333.
Summing up, then, by moving all the corporate property and your two employees to Nevada, you would reduce the business profit subject to California tax from $400,000 to $100,000.