Now I Understand

The following question was posed several weeks ago on the MSBA's Section of Business Law listserve:

Is anyone familiar with a company called Advantage Corporation Services? They are encouraging business formation in Nevada because of the favorable statutes and regs for business. I have a potential client that has allowed this company to start on formation paperwork for him however now they want him to be his own resident agent in Maryland which will be his primary place of business . . . .[A]ny information would be helpful.

My response at the time was:

There are a host of companies that "push" Nevada as the state of domestication for corporations and LLCs based upon alleged benefits that are, so far as I can determine, illusory. By way of example, I've heard of an individual who formed an LLC in Nevada because he was assured that Nevada would only turn over the ownership info concerning the LLC if it received a subpoena. I then informed him that Maryland went one step further, since it didn't have any ownership info to begin with and even if it received a subpoena would therefore not turn over any ownership info.

There were other, similar, responses.

Yesterday, the LAT had an article, Tax-Averse Firms Cross a State Line, (registration required) where it reported that a large number of California businesses were incorporating in Nevada to avoid California state taxes.

No need for savvy accountants or high-priced lawyers. Seminars, webcasts and radio advertisements bray that it's easy to slash a California tax bill — or eliminate it altogether — by creating a corporation in Nevada, where there is no income tax on businesses or individuals. Set one up online with a few keystrokes and a $395 credit card payment! For a little extra, a Nevada mailing address, telephone number and bank account can be added.

Promoters peddling the packages call it good tax planning. California officials call it something else: tax fraud. They say the cash-strapped state's coffers are being drained as even some of the smallest California businesses shift their profits into hastily created corporate shells in the Silver State.

"We want to catch this scam before it gets out of hand," said state Controller Steve Westly. "We think it will cost the state tens of millions of dollars if this continues."

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Nevada corporate secrecy laws can make it impossible to unearth how exactly money is being used once it is shifted there. Unlike most other states, Nevada doesn't work cooperatively with the IRS to root out tax cheats — something the office of the Nevada secretary of state highlights in a pamphlet titled "Why Incorporate in Nevada?"

Part of the scam, sorry, legitimate planning strategem, frequently involves:

[S]etting up a Nevada corporation to own all of a company's equipment — ovens for a bakery, for example, or maybe computers and fax machines for a travel agency. But no baking or travel planning is being done in Nevada. No one involved in the business is even located there. Everything is still happening in California.

The owners simply use the Nevada company to lease the equipment back to the store in California. The cost of the lease cancels out California profits, possibly eliminating taxes owed there. The profit gets shifted to Nevada, which has no corporate or personal state income tax.

The use of the scam strategy appears to work, in part, because of the apparent difficulties faced by California audit personnel in attempting to obtain information via administrative subpoena in Nevada. The problem has been exacerbated by the Supreme Court's ruling in Franchise Tax Bd. of Cal. v. Hyatt, 538 U.S. ___ (2003), which held that the doctrine of comity did not compel the Nevada courts to honor the California taxing authority's claim that sovereign immunity provided a shield against claims for intentional torts.

"It makes it a little more scary to audit someone in Nevada," said Frank Katz, general counsel for the Multistate Tax Commission, an organization of state governments working to make tax collections more efficient. "The person can now just sue you there."

Given the possibility that this gambit threatens to rip a wide hole in California's tax collection mechanism, I suspect that the state's tax administrators and its courts will rise to the occasion and devise appropriate plugs. Tax avoidance should be more than a $395 credit card charge and a wink and a nod.