Delaware or California? Your Guide to Choosing the Right Destination for Forming Your Limited Liability Company

If you're thinking about forming a limited liability company or you have already done so, you likely have asked yourself, "Should I form my limited liability company in Delaware or California?" The answer to this question is almost always "it depends," but understanding the basics of the analysis is helpful.

This blog post focuses on the laws of the jurisdictions of both Delaware and California so you can get a birds-eye view of the issues to consider when determining where to form your limited liability company (LLC).

Key Takeaways

• Deciding which jurisdiction of formation is right for your business, is a complex process

• Personal liability is often a major concern, but other points of interest are ownership requirements, form of equity and transfer of interests, formation and filing fees, governing documents, management, fiduciary duties and distributions

• For small California businesses, forming/organizing in California is often the better choice

BACKGROUND AND GOVERNING LAW

Delaware LLCs are governed by the Delaware Limited Liability Company Act (Delaware LLC Act) (6 Del. C. §§ 18-101 et seq.). California LLCs are governed by the California Revised Uniform Limited Liability Company Act (RULLCA) (Cal. Corp. Code §§ 17701.01 et seq.). 

These jurisdictions are the most often cited locations for organization among people we work with. However, there are other jurisdictions like Nevada and Alaska that are often good choices for businesses, depending on the situation and circumstances. Which jurisdiction is right for you is a matter of many different considerations and is best determined by a professional.

The following blog post provides insight into the differences between LLCs organized in Delaware and California. For information on different entity types in Delaware and California, or which jurisdiction is right for you, give us a call and we'll set up a strategy session.

While there are many different issues to consider when forming an LLC, choosing the jurisdiction of organization is often of particular concern because people have "heard" choosing Delaware is a good idea, and many of the country's most successful businesses are organized/formed there. However, determining which jurisdiction to choose depends on several factors, including:

• The location of the LLC's offices.

• Where the LLC intends to conduct business.

• The type of business in which the LLC will engage (for example, some states may highly regulate a particular type of business while other states have no oversight).

As a preliminary matter, it should be noted that the jurisdiction selected for organization may affect things like benefits available for employees and owners, licensing and permitting that is necessary, among other topics. These particular issues fall outside the scope of this blog post. That said, if you have questions regarding ancillary issues related to choosing the state of organization for your LLC, please don't hesitate to call us and set up a strategy session.

Also, we are a California law firm. This means that we help businesses that operate in California. To the extent that it makes sense for these businesses to organize outside of California, this is something we can address in our representation.

Finally, and because most LLCs are treated as partnerships or disregarded entities for US federal income tax purposes, this blog post assumes that is the case for the proposed LLC to be formed. The tax consequences of forming an LLC are complex and can vary depending on the type of business, the type of owners, applicable tax laws, and other circumstances. Before forming an LLC in any jurisdiction, you should consult with a tax professional familiar with both state and federal taxation issues in conjunction with your attorney.

Please do not rely on accountants, CPAs, or others in the tax industry that are not lawyers for legal advice. We find that people often get this sort of legal advice from their accountants. This is not only irresponsible and professionally unsound on the accountants' parts, but a questionable decision from a consumer perspective. Accountants should give tax advice. Lawyers should give legal advice. It's that simple.

To the extent the issues of taxes and the law overlap, these professionals should work in conjunction with one another for the consumer. Some basic state tax information is available from the Delaware Department of Finance and the California Tax Service Center. Again, if you have tax concerns as they relate to your small business, you are more than happy to address them. 

OWNERSHIP REQUIREMENTS

Delaware LLCs can have one or more members (6 Del. C. § 18-101(6)), but two or more members required if the LLC wants to be taxed as a partnership (Treas. Reg. § 301.7701-3). There are no restrictions on the types of owners, and the LLCs can admit a member without any contribution (6 Del. C. § 18-301(d)).

A Delaware series LLC may be organized with different series (divisions or units) of members, managers, LLC interests, or assets. Each series may have separate rights, powers, or duties regarding specified property or obligations (6 Del. C. § 18-215(a)). For more information about series LLCs, get in touch!

Comparatively, California LLCs can also have one or more members (Cal. Corp. Code §§ 17702.01(a) and 17701.02(s)), and two or more members are also required if LLC wants to be taxed as a partnership (Treas. Reg. § 301.7701-3). California law establishes that a California LLC is considered a separate entity from its members (Cal. Corp. Code § 17701.04(a)). Like Delaware LLCs, there are no restrictions on the types of owners, and the LLCs can admit a member without any contribution (Cal. Corp. Code § 17704.01(d)).

As to the series LLC, these cannot be created in California, but if formed in another state, a series LLCs can register and transact business in California. For general information in this regard, visit California Franchise Tax Board: Series Limited Liability Company (Series LLC).

FORM OF EQUITY AND TRANSFER OF INTERESTS

Delaware LLC interests are held by one or more members (6 Del. C. § 18-101(8)), and the LLC agreement may provide for more than one class or group of members (6 Del. C. § 18-302(a)). After formation of a Delaware LLC, additional LLC interests can be issued as provided in the LLC agreement or, if the LLC agreement is silent, only with consent of all members (6 Del. C. § 18-301(b)(1)).

A Delaware LLC interest is assignable in whole or in part except as provided by the LLC agreement. The assignee may not participate in the management of the LLC's business and affairs except as provided by the LLC agreement or, unless otherwise provided in the LLC agreement, on the vote or consent of all members (6 Del. C. § 18-702(a)).

In the event of assignment, the assignee becomes a member as provided in the LLC agreement. This is the case unless otherwise provided in the LLC agreement, whereupon membership is determined by the vote or consent of all the members or, if there is a single member, the sole member's voluntary assignment of all the LLC interests is to a single assignee. (6 Del. C. § 18-704(a).)

California LLC membership interests are held by one or more members, and the Articles of organization or operating agreement may provide for more than one class of member (Cal. Corp. Code § 17712.01). After formation of a California LLC, a person can become a member as provided in the operating agreement, by unanimous member consent, resulting from a merger or conversion, or within 90 days after the day the LLC ceases to have members, if the last member or the member's legal representative designates a person to become a member and the designated person consents. (Cal. Corp. Code § 17704.01(c).)

Unless otherwise provided by the a California LLC operating agreement, the right to receive distributions (transferable interest) is transferable (Cal. Corp. Code § 17701.02(aa)), and the transfer of a transferable interest does not entitle the transferee to vote or otherwise participate in the LLC's management. (Cal. Corp. Code § 17705.02(a)(1), (a)(3)(A).)

FORMATION DOCUMENTS AND FILING FEES

Delaware LLCs require that a Certificate of formation is filed with the Delaware Secretary of State (SOS) (6 Del. C. § 18-201(a). Filing fees for this are $90 (see Delaware Department of State, Division of Corporations: Corporate and UCC Fee Information).

California LLCs require that Articles of organization are filed with the California Secretary of State (Cal. Corp. Code § 17702.01. Filing fees this are comparable to Delaware as they stand at $70 for the articles of organization (Cal. Gov. Code § 12190(b) and see California Secretary of State: Forms, Samples and Fees).

GOVERNING DOCUMENTS

To form a Delaware LLC, you'll various documents that govern the LLCs. These documents include a Certificate of formation and LLC agreement, which may be written or oral (6 Del. C. §§ 18-201(a) and 18-101(7)). The type of governing document you need will depend on the structure that is right for your LLC.

We prepare the following types of governing documents for those looking to form a Delaware LLC: Certificate of Formation; LLC Agreement (Multi-Member, Manager-Managed); LLC Agreement (Multi-Member, Manager-Managed); LLC Agreement (Single Class, Multi-Member); LLC Agreement (Single Member); and LLC Agreement (Operating Company).

California LLCs also require specific governing documents upon formation. These documents include the Articles of organization and operating agreement, which also may be written or oral (Cal. Corp. Code §§ 17701.02(s), 17701.10, and 17702.01). Again, the type of governing document that is best for your venture will depend on the structure that is best for your LLC.

We prepare the following types of governing documents for those looking to form a California LLC: Operating Agreement (Multi-member, Manager-Managed); Operating Agreement (Multi-Member, Manager-Managed); and Operating Agreement (Single Member).

In California, the operating agreement may waive or modify many of the default statutory provisions (Cal. Corp. Code § 17701.10(b)), but certain provisions cannot be waived or modified in the operating agreement, or may only be modified within certain parameters (Cal. Corp. Code § 17701.10(c)-(d), (g); for more information, ask us about RULLCA Default and Non-Modifiable Provisions).

LIABILITY

Delaware LLC members and managers are not liable for the LLC's debts, obligations, and liabilities, except as provided by the Delaware LLC Act or the LLC agreement (6 Del. C. § 18-303).

Similarly, California LLC law provides that unless otherwise provided by the operating agreement, a member or manager is not liable for the LLC's debts, obligations, or other liabilities solely by reason of acting as a member or a manager (Cal. Corp. Code § 17703.04(a)).

California law goes further to provide that a member is only personally obligated under certain limited circumstances, such as an agreement by the member in the articles or a written operating agreement to be personally obligated (which must reference Cal. Corp. Code § 17703.04(e)) or liability under the common law governing alter ego liability (Cal. Corp. Code § 17703.04(b), (e)). For further discussion about personal liability and California LLCs, ask us about California LLC Member liability and indemnification in the context of a California Operating Agreement (Single Member), as well as piercing the corporate veil in California LLCs and fiduciary duties and limiting liability in California LLCs.

MANAGEMENT (GOVERNING AUTHORITY)

A Delaware LLC is governed by its members, unless the LLC agreement provides otherwise, and the LLC agreement may provide for management, in whole or in part, by one or more managers. (6 Del. C. § 18-402.) Delaware LLC members can delegate management to a managing member, non-member manager, or board of managers.

A Delaware LLC has no requirements for officers. However, and unless the LLC agreement provides otherwise, a member or manager may delegate to officers its rights and powers to manage and control the LLC's business and affairs. Unless the LLC agreement provides otherwise, the delegation does not make the officer a member or manager, nor does the member or manager cease to be a member or manager. (6 Del. C. § 18-407.) Also, and unless otherwise provided by the LLC agreement, certain acts, such as admitting new members or dissolving the LLC, require unanimous or supermajority approval of the members, as applicable (6 Del. C. §§ 18-301(b) and 18-801(a)(3)).

A California LLC is also governed by its members, but in this case it's the articles of organization that can provide that it will be manager-managed (Cal. Corp. Code § 17704.07(a)). California is the same as Delaware in that a California LLC also has no requirements for officers. Insofar as the LLC has officers, any officers are appointed in accordance with a written operating agreement, or if the operating agreement is silent, by the managers (Cal. Corp. Code § 17704.07(v)).

California LLCs differ form Delaware LLCs in that unless otherwise provided by the operating agreement, acts outside the ordinary course of the LLC's activities require consent of all members (whether the LLC is member-managed or manager-managed); remember Delaware LLCs can either require unanimous support or a supermajority for approval of certain acts. Separate rules apply to conversions and mergers or California LLCs. (Cal. Corp. Code § 17704.07(b)(4), (c)(4) and see Cal. Corp. Code §§ 17710.03(b)(1) and 17710.12(a)).

FIDUCIARY DUTIES

For Delaware LLCs, managing members and managers owe the fiduciary duties of care and loyalty (CMS Inv. Holdings, LLC v. Castle, 2015 WL 3894021, at *18 (Del. Ch. Jun. 23, 2015)), unless provided otherwise in the LLC agreement. The LLC agreement may expand, restrict, or eliminate duties (including fiduciary duties) and limit or eliminate member or manager liability for breaches of those duties but may not eliminate the implied contractual covenant of good faith and fair dealing. The LLC agreement also may not limit or eliminate liability for breach of contract or breach of duty for acts or omissions that constitute a bad faith violation of the implied contractual covenant of good faith and fair dealing. (6 Del. C. § 18-1101(c), (e)).

Delaware LLC members and managers are shielded from liability in that they can rely in good faith on information, opinions, reports, or statements from other members, managers, officers, employees, committees, or any other person regarding matters the member or manager reasonably believes are within that person's professional or expert competence (6 Del. C. § 18-406).

For California LLCs, members in a member-managed LLC and managers in a manager-managed LLC owe a fiduciary duty of loyalty and care to the LLC and the other members (Cal. Corp. Code § 17704.09(a)-(c), (f)(1)). A California LLC operating agreement can generally modify these duties, but unlike Delaware LLCs, California LLCs cannot eliminate these duties through agreement. Also, any changes are subject to statutory limitations on modification (Cal. Corp. Code § 17701.10(c)-(g)).

Just like in Delaware, a California operating agreement may not eliminate the obligation of managers or members of good faith and fair dealing (Cal. Corp. Code § 17704.09(d), (f)(2)). However, California provides that California LLC operating agreements may prescribe standards (which may not be manifestly unreasonable) by which performance of the obligation is measured (Cal. Corp. Code § 17701.10(c)(5)). Similarly, an operating agreement may not unreasonably reduce the duty of care (Cal. Corp. Code § 17701.10(c)(15)).

Also, a California LLC operating agreement may not eliminate the duty of loyalty, but RULLCA does not prohibit modification. Therefore, an operating agreement may identify activities (which may not be manifestly unreasonable) that do not violate the duty, and specify the number or percentage of members that may authorize or ratify acts or transactions that would otherwise violate the duty. (Cal. Corp. Code § 17701.10(c)(14).)

For more information, ask us about Fiduciary Duties for members of California LLCs.

DISTRIBUTIONS

For Delaware LLCs, members are not entitled to demand and receive distributions in any form other than cash, except as provided in the LLC agreement. Moreover, a member cannot be compelled to accept a distribution of any asset in kind to the extent that the percentage of the asset distributed exceeds a percentage of that asset that is equal to the percentage in which the member shares in distributions (6 Del. C. § 18-605), except as provided in the LLC agreement.

Delaware LLC distributions are allocated among the members as provided by the LLC agreement. If the LLC agreement is silent, distributions are made based on the agreed value of each member's unreturned contributions (6 Del. C. § 18-504). Distributions cannot be made if after giving effect to the distribution the LLC's liabilities (other than certain liabilities) exceed the fair value of its assets (with the fair value of certain property excluded) (6 Del. C. § 18-607(a)).

A member who knowingly receives an improper distribution is personally liable for the amount of the distribution (6 Del. C. § 18-607(b)). Also, and unless provided otherwise in the LLC agreement, a member that is entitled to a distribution has the same status and remedies as a creditor of the company (6 Del. C. § 18-606).

Like Delaware LLCs, California LLC members are not entitled to receive or demand distributions in any form other than cash (Cal. Corp. Code § 17704.04(c)), unless provided otherwise in the operating agreement. As to distributing assets other than cash, an LLC may distribute assets other than money if each part of the asset is fungible, and each member receives a percentage of the asset equal to the member's share of distributions, unless provided otherwise in the operating agreement. (Cal. Corp. Code § 17704.04(c).)

California LLC distributions are made on the basis of the value (as stated in the LLC's required records) of each member's contributions (Cal. Corp. Code § 17704.04(a)), unless otherwise provided in the operating agreement. This rule is limited in that a California LLC cannot make a distribution if after the distribution either the LLC would be unable to pay its debts as they become due in the ordinary course of its activities, or the LLC's total assets would be less than the sum of its total liabilities and the amount needed, if the LLC were then dissolved, to satisfy preferential rights of members whose preferential rights are superior to those of the members receiving the distribution. (Cal. Corp. Code § 17704.05(a).)

A California member of a member-managed California LLC or manager of a manager-managed California LLC who consents to an improper distribution is personally liable to the LLC for the amount in excess of the legally permissible distribution (Cal. Corp. Code § 17704.06(a), (b)). Unless provided otherwise in the operating agreement, an LLC's indebtedness incurred by reason of a distribution to a member is at parity with indebtedness owed to a general, unsecured creditor of the company (Cal. Corp. Code § 17704.05(d)).

If you're looking to form a limited liability company, we can guide you through the decision-making process and find a solution for you. Ask about our Layaway Payment Plan, which is a pay-as-you-go option for those on a tight budget. If you’d like guidance and assistance with other business transactions, schedule a strategy session today; we're happy to help.

Matthew Schlau is a co-founding principal of Schlau|Rogers and an estate and business planning lawyer practicing in Orange, San Diego, Los Angeles and Riverside counties. He is a husband, father, blogger, crossfitter, and really good at helping people achieve their goals.

At Schlau|Rogers, we do more than just estate and business planning, probate and trust administration. Our objective is to provide individually-tailored plans that allow you the opportunity to reach your goals, all while minimizing headaches and risk, and maximizing peace of mind.

On our blog, you'll find useful information about estate and business planning, probate and trust administration, as well as some tidbits on personal finance, taxes, and anything else we think will help minimize headaches, worry and risk, all while maximizing peace of mind.

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