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Using Nevada Corporations and LLCs for Non-Nevada Residents: Separating Fact from Hype.
A few jurisdictions, especially Nevada, Wyoming, and Delaware, are heavily marketed as offering superior asset protection. Is there any substance behind the hype? The answer is only a little, and for the most part no. Forming a corporation or LLC in the state of Nevada (which is notorious as the state of choice in which to domicile egregiously bad asset protection plans) may even raise a red flag that could weaken the effectiveness of a plan, unless of course the entity actually conducts business there. An example of this notoriety can be found in a report by a senior IRS director (small business division) wherein he states:
“…non-compliant taxpayers, including non-filers, fraudulent taxpayers, abusive promoters and under-reporters, have taken advantage of certain state laws, particularly in Nevada. Nevada has laws that may be used to help hide the identity of the non-compliant taxpayers; these laws are perceived by some taxpayers as available to facilitate taxpayer non-cooperation with the IRS; and non-compliant taxpayers may take advantage of an established industry for forming and servicing corporate entities. …The IRS has authorized several investigations … into promoters of Nevada corporations and resident agents. These investigations have revealed widespread abuse, as well as problems in curtailing that abuse. …our office, as a result of several promoter investigations has obtained client lists that are being used as a source for potential non-filer audits. An initial sampling of the client lists showed that anywhere from 50 to 90 percent of those listed are currently, or have been previously, non-compliant with Federal tax laws. …While the non-compliance rates found in the client samples of the promoters we have investigated (50 to 90 percent) are probably not the norm across all Nevada corporations, even if non-compliance is a fraction of those numbers the potential loss to the Treasury is still considerable. … we are contemplating mass audits of non-filers that would produce a list of non-filer and non-compliant participants. …the Service will consider “John Doe summonses” to resident agents. The summonses would be similar to the ones issued to credit card companies related to the use of offshore credit cards. Nevada resident agents and incorporation companies provide a legitimate service to a group of unknown “Does” whom the Service has reason to believe are using these valid services to abuse the tax system.”[i]
The foregoing alone ought to discourage a non-Nevada resident from using a Nevada corporation for asset protection. However, there is more to choosing the state one forms an entity in than the reputation of its entities. We should also address choice-of-laws concerns, which are especially important when choosing an entity’s domicile as part of an asset protection plan. Perhaps the greatest motivation for a client do asset protection is to protect their wealth from lawsuits. The source of most lawsuits to which asset protection planning is most relevant, of course, is an alleged tort of one kind or another. Contrary to the claims of various Nevada/Delaware/Wyoming incorporation promoters, in regards to such litigation the laws of an entity’s domicile will likely not govern alter ego, reverse-piercing, and fraudulent transfer issues. Rather, the governing law will likely be determined according to a legal maxim known as “lex loci delicti”, which means the “law of the place where the tort was committed”.[ii] This doctrine has evolved somewhat over time, as was noted, among other cases, in Higashi v. Brown, which states:
“Two tests have evolved over time to determine the proper choice of law in tort cases. The first is the "lex loci delicti" rule. Under this older rule, the law of the place of the wrong was uniformly applied to all tort cases. In later cases, however, the place of injury alone was not the controlling factor. Armstrong v. Armstrong, 441 P.2d 699, 701 (Alaska 1968). Alaska has now adopted a second test, "the most significant relationship" test, for conflicts of law questions. It requires the court to consider:
(a) the place where the injury occurred, (b) the place where the conduct causing the injury occurred, (c) the domicil[e], residence, nationality, place of incorporation and place of business of the parties, and (d) the place where the relationship, if any, between the parties is centered. These contacts are to be evaluated according to their relative importance with respect to the particular issue.”[iii]
Some asset protection planners claim the law mandates the jurisdiction of an entity’s domicile must govern matters of liability where managers or owners of the entity are concerned. The defendants in the case Butler v. Adoption Media, LLC made this exact argument, by stating that an Arizona LLC should be interpreted according to California rather than Arizona law (California being where the alleged tort occurred). However, the court in this case disagreed:
“Defendants argue that Arizona law applies because the Beverly-Killea Limited Liability Company Act, Cal. Corp.Code § 17000, et seq., provides for the application of the law of the state of organization (here, Arizona) to issues of liability between an LLC and its management and officers as well as to issues concerning the organization of the LLC. Cal. Corp.Code § 17450(a) (“The laws of the state ... under which a foreign limited liability company is organized shall govern its organization and internal affairs and the liability and authority of its managers and members.”). The court finds, however, that § 17450(a) simply codifies the internal affairs doctrine, as applied to LLCs. [FN1][iv] In other words, § 17450(a) does not apply to disputes that include people or entities that are not part of the LLC.”[v]
The internal affairs doctrine, in general, says that the state of domicile governs an entity’s internal affairs between itself, its managers or directors, and its owners. However, in Butler the court ruled that this does not extend to disputes with 3rd parties (although it’s certainly conceivable that other courts in other jurisdictions may rule otherwise). Therefore, of the four criteria listed in Higashi for determining which laws will govern a limited liability entity involved in tort litigation with a 3rd party plaintiff, the place of the entity’s incorporation or organization is probably the least important determining factor. Finally, even a dispute involving only parties related to a particular entity does not guarantee the internal affairs doctrine will govern the case at hand, as was demonstrated in Greenspun v. Lindley, wherein the court found “in consequence of significant contacts with New York State, … this investment trust, although a Massachusetts business trust, was nonetheless so "present" in our State as perhaps to call for the application of New York law. In that sense we reject any automatic application of the so-called "internal affairs" choice-of-law rule…”[vi] The foregoing does not mean that the laws of a state where a limited liability entity is domiciled will never be used, if a case is tried in another jurisdiction. However, it does mean one should not count on the laws where there entity is domiciled to save the day in all circumstances. In conclusion, the jurisdiction under which an entity is formed has a lot less to do with how its limited liability holds up than some asset protection promoters would have one believe. For this reason, if an entity is conducting intrastate business in one or only a few states, it should probably be formed in one of the states wherein it operates. However, an entity that is not conducting intrastate business in any given state (which would relieve it of the requirement of registering in a particular state, other than where it’s formed) may want to consider which jurisdiction is best for tax, ease-of-operation, and financial privacy reasons. (Those wishing to form an entity for legal financial privacy purposes should read the section entitled “Anonymous LLCs” in the chapter in this book regarding limited liability companies.)
WHAT FOLLOWS IS AN EXAMPLE OF WHY NEVADA CORPORATIONS AND LLCS HAVE DEVELOPED A BAD REPUTATION AND THUS SHOULD PROBABLY BE AVOIDED, UNLESS THE OWNERS LIVE OR CONDUCT BUSINESS IN NEVADA. THE PROMOTER MENTIONED BELOW PREDOMINANTLY USED NEVADA CORPORATIONS TO CARRY OUT HIS VARIOUS SCHEMES.
[i] Written Testimony of K. Steven Burgess, Director, Examination Small Business/Self Employed Division, Internal Revenue Service, Before Senate Committee on Homeland Security And Governmental Affairs, Permanent Subcommittee on Investigations, Hearing on Company Formations: Minimal Ownership Information Is Collected and Available. (November 14, 2006.) [ii] See Drenis v. Haligiannis, 452 F.Supp.2d 418 (S.D.N.Y. 2006), an excerpt of which says: “Typically where there is a conflict of law in cases involving tort claims, New York applies an ‘interest analysis' to identify the jurisdiction that has the greatest interest in the litigation based on the occurrences within each jurisdiction, or contacts of the parties with each jurisdiction, that relate to the purpose of the particular law in conflict. Pension Comm. of Univ. of Montreal Pension Plan v. Banc. of Am. Secs., LLC, 446 F.Supp.2d 163, 192 (S.D.N.Y.2006) (internal quotation marks and citation omitted). When the law is one which regulates conduct, such as fraudulent conveyance statutes, see GFL Advantage Fund, Ltd. v. Colkitt, 03 Civ. 1256, 2003 WL 21459716, at *3 (S.D.N.Y. June 24, 2003), the law of the jurisdiction where the tort occurred will generally apply because that jurisdiction has the greatest interest in regulating behavior within its borders, Pension Comm., 446 F.Supp.2d at 192 (quoting GlobalNet Financial.com, Inc. v. Frank Crystal & Co., Inc., 449 F.3d 377, 384 (2d Cir.2006).) A tort occurs in the place where the injury was inflicted, which is generally where the plaintiffs are located. Id. (quoting Cromer Fin. Ltd. v. Berger, 137 F.Supp.2d 452, 492 (S.D.N.Y.2001)).” [iii] Higashi v. Brown, In re: Case No. A95-00200-DMD (Fed. B. Alaska, 2006.) Note that this or very similar tests seem to now be the norm in most U.S. states. [iv] Footnote 1 from Butler v. Adoption Media, LLC is as follows: “Under the "internal affairs" doctrine, which is followed in most states, the law of the state of incorporation governs liabilities of officers or directors to the corporation and its shareholders. Shaffer v. Heitner, 433 U.S. 186, 215 n. 44, 97 S.Ct. 2569, 53 L.Ed.2d 683 (1977); see also CTS Corp. v. Dynamics Corp. of America, 481 U.S. 69, 89, 107 S.Ct. 1637, 95 L.Ed.2d 67 (1987); Rest. (Second) of Conflict of Laws § 309 and comment (a). Internal corporate affairs involve those matters that are peculiar to the relationships among or between the corporation and its current officers, directors, and shareholders. Edgar v. MITE Corp., 457 U.S. 624, 645, 102 S.Ct. 2629, 73 L.Ed.2d 269 (1982); see Rest. (Second) of Conflict of Laws § 313, comment (a). In general, courts in California follow this rule and apply the law of the state of incorporation in considering claims relating to internal corporate affairs. See Cal. Corp.Code § 2116 (directors of foreign corporation transacting intrastate business are liable to corporation for making of unauthorized dividends, purchase of shares or distribution of assets of false certificates, reports or public notices or other violation of official duty according to applicable laws of state of incorporation); see also Batchelder v. Kawamoto, 147 F.3d 915, 920 (9th Cir.1998).” [v] Butler v. Adoption Media, LLC, 2005 WL 2077484 (N.D.Cal.). [vi] Greenspun v. Lindley 36 N.Y.2d 473; 330 N.E.2d 79; 369 N.Y.S.2d 123; 1975 N.Y. LEXIS 1826; 88 A.L.R.3d 697. One should note that this case involved a dispute between a business trust’s trustees and its shareholders, which the court held was analogous to a dispute between the directors and shareholders of a standard corporation.
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