Since it became the first state to ratify the U.S. Constitution in 1787, Delaware has maintained a low profile as far as states go, yet technically it's home to a stunning amount of businesses.
Like its official state bug, the ladybug, most people think positively of Delaware, if they think of it all, but nonresidents probably don't know much about "The First State." Nonetheless, Delaware has become a hotbed for business -- or at least for the paperwork involved in creating business. More than 60% of publicly traded companies are incorporated in the second-smallest state, according to The New York Times, so what it lacks in land mass it more than makes up for in influence.
The vast majority of these companies have headquarters elsewhere, making them Delawareans in name only, but the state has still built up a nice business as a place to incorporate businesses. An earlier Times article reported that "Delaware collected roughly $860 million in taxes and fees from its absentee corporate residents" in 2011, a quarter of the state's total budget for the year.
By being business-friendly, offering low taxes, and making it very easy to set up shell companies -- business entities that have no operations or assets, but can be used for legal tax avoidance -- Delaware has become the go-to place for legitimate (and less legitimate) companies to incorporate. That has given the state both revenue and power.
"This critical mass means that Delaware decides how companies are governed and is so prominent that its decisions on corporate law influence how other state courts act," according to last week's Times article.
Delaware has aggressively marketed itself as a place to incorporate in order to lower your tax bill, even issuing a paper in 2007 titled "Why Corporations Choose Delaware."
That document, distributed by the Delaware Department of State Division of Corporations, makes a compelling case for incorporating in the state, including:
- The Delaware General Corporation Law is one of the most advanced and flexible corporation statutes in the nation.
- Delaware's courts and, in particular, the state's highly respected corporations court, the Court of Chancery, a court which is specifically devoted to settling business disputes where experienced judges here cases and no juries are involved (which is generally considered favorable for businesses).
- The state legislature "takes seriously its role in keeping the corporation statute and other business laws current."
- The Secretary of State's Office, "which thinks and acts more like one of the corporations it administers than a government bureaucracy."
The paper lists more, many more, reasons, but the Times in 2012 nailed the No. 1 reason:
It is also a great place to reduce a tax bill. Delaware today regularly tops lists of domestic and foreign tax havens because it allows companies to lower their taxes in another state -- for instance, the state in which they actually do business or have their headquarters -- by shifting royalties and similar revenues to holding companies in Delaware, where they are not taxed.
Widely known as "the Delaware loophole," the paper reported, the rules allowed businesses to reduce taxes paid to other states by an estimated $9.5 billion between 1992 and 2012.
The loophole is not quite as simple as "incorporate in Delaware and pay no taxes." The state actually has a relatively high corporate tax rate of 8.7%, but "Delaware does not tax certain profit-making intangible items — like trademarks, royalties, leases and copyrights," Bradley P. Lindsey, an accounting professor at North Carolina State University and one of three authors of a 2011 study Exploring the Role Delaware Plays as a Domestic Tax Haven, told the Times. Some companies exploit this by transferring these intangible items to shell corporations in Delaware, then paying significant "royalty fees" from the pool of revenue generated elsewhere. In doing this, they transfer taxable revenue into tax-exempt profits.
While this arrangement has drawn concern because the rules can be used to benefit illicit corporations as well as legitimate ones, it has been beneficial to the state and countless companies. Delaware's coffers have grown fat with fees from the deals, and being a haven for incorporation has led to job creation in the state -- albeit at law firms that aid in the process, not businesses that make or do anything.
Of course, what's good for Delaware is bad for the other states that lose out on tax revenue. But as long as there are no federal standards for incorporation, companies will continue to exploit this situation and Delaware will gladly profit off it.
Daniel Kline owns shares of Apple. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.