November 20, 2016

The “Delaware Advantage” Applies to Nonprofits, Too

It is safe to say that Business Law Today readers are aware that a disproportionate number of incorporations take place in Delaware (as of last year, 66 percent of Fortune 500 companies were incorporated in Delaware, and 86 percent of 2015 IPOs involved a Delaware entity) and are familiar with the reasons why: a well-developed body of case law that provides predictability; statutes that provide flexibility and are continuously updated; a well-respected judiciary and dedicated forum for disputes, the Delaware Court of Chancery; experienced service providers; and a customer-service oriented and efficient secretary of state. However, many may not be aware of the compelling reasons nonprofits, in particular, choose to use Delaware entities. Although most nonprofits are formed under the laws of their home state, it is quite common for experienced nonprofit practitioners to recommend a Delaware entity. This article examines why and provides the perspective of a New York practitioner who frequently uses Delaware entities in her nonprofit practice.

Let us begin with the obligatory disclaimer: Delaware incorporation is not the best choice for every nonprofit, but can be very advantageous under the right circumstances. It is important to be aware upfront that there are some built-in costs for out-of-state nonprofits that choose to form as Delaware entities, such as the requirement of maintaining a registered agent in Delaware and the likelihood of having to pay fees in both Delaware and the state of domicile. That said, consider the following advantages:

  1. Ease of formation—no prior approval needed from state agencies. In Delaware, a nonprofit is formed by filing a certificate of incorporation with the customer-service oriented Delaware secretary of state. Other states (e.g., California and New York) require prior consent from certain state agencies (and which one(s) may depend on the purpose of the nonprofit). Navigating the complexities and bureaucracy can result in significant cost and delay in some states.
  2. No state agency approval needed for amendments, either. Delaware does not require any state agency approval for amendments, mergers, dissolutions, or other filings with the Delaware secretary of state. This means that changes can be made nimbly and without incurring significant cost. This is not true in many other states and, even where agency approval is not specifically required, their secretary of state offer timely service only at a significant premium or not at all.
  3. No registration with the attorney general or equivalent office. In Delaware, no state statute requires registration of charities. Although the attorney general’s office provides general oversight of charities, unlike many other states, Delaware does not require that nonprofits formed under Delaware law register with and file separate annual financial reports with the attorney general. If the nonprofit is conducting activities in Delaware, it must file a copy of its federal Form 990 with the Delaware attorney general.
  4. Permissive, rather than prescriptive, corporate governance. Delaware does not have a separate nonprofit statute. Delaware nonprofits typically are formed as nonstock corporations governed by the well-developed and consistently updated Delaware General Corporation Law, allowing for flexibility with regard to governance and structuring of the organization. For example, Delaware requires members for nonstock corporations, but allows the directors to serve as the only members, allows as few as one director, and does not require a majority disinterested board. These factors, combined with the fact that Delaware allows for, but does not require, the election of a corporate officer can make the initial start-up of a nonprofit very simple.
  5. Tax advantages. Delaware 501(c) corporations are automatically exempt from Delaware corporate income tax and are exempt from Delaware franchise tax. Exemptions are also available from obtaining a Delaware business license and paying gross receipts tax on the sale of most goods and services and from various state and local real property taxes.

These are real advantages that can save clients significant time and expense. How all of this plays out in practice varies given the specific factual situation and what other state(s) might be considered. However, it is safe to say that nonprofits with a global focus, or those based out of California or New York, may be especially suited for Delaware incorporation. The perspective of an experienced New York nonprofit practitioner is illustrative.

A New York Practitioner’s Perspective

Most New York nonprofit practitioners vastly prefer forming corporations in Delaware over New York. We have even had clients ask after the fact about changing domicile from New York to Delaware. Although some states allow corporations to easily change domiciles, both the original domicile and the new domicile must allow for the change under their respective state laws. Although Delaware allows corporations to change domiciles, New York does not. Thus, a New York corporation seeking to redomicile in Delaware would have to form a Delaware corporation and merge the New York corporation into the Delaware corporation, with the Delaware entity surviving the merger. However, a merger of a New York charitable corporation into a foreign corporation requires approval by the New York Charities Bureau. The Charities Bureau generally will grant such approval if it is satisfied that the interests of the constituent corporations and the public interest will not be adversely affected by the merger. It is unclear, however, whether the Charities Bureau would approve the merger of a New York charitable corporation into a Delaware corporation simply for the purpose of changing venue.

Incorporation in Delaware is quick and painless, whereas the New York State Department of State regularly rejects certificates of incorporation, causing delays in incorporation as well as increased legal fees relating to time spent negotiating with the state and revising the language of the certificate. The New York Nonprofit Revitalization Act of 2013 enacted a number of changes designed to lessen these issues, but it is still much more of a trial to incorporate in New York than in Delaware. New York also has a variety of state governmental agencies (e.g., the Department of Education, Department of Health) from which consent to formation is required where the purposes of the corporation will bring the organization under such agencies’ jurisdiction. (In such a case, relevant agency consent is needed if the corporation were formed in Delaware and then applies for authority to conduct activities in New York, but at least the original incorporation would not be delayed, which can be important in terms of the retroactivity of the organization’s eventual tax exemption.) Amending an organization’s certificate of incorporation is also easier outside of New York, where changes to a charitable corporation’s corporate purposes must go through an attorney general approval process.

Another major difference between New York and Delaware is that Delaware does not have an attorney general with an active charity oversight function. Again, similar to (and in addition to) applying for authority in New York, Delaware nonprofits operating in New York still must register with the New York Charities Bureau, subjecting them to attorney general oversight (and rightly so), but foreign corporations are not subject to most of the New York Not-for-Profit Corporation Law provisions that are so burdensome to New York charities, such as the detailed and specific rules regarding conflict of interest policies, whistleblower policies, and investment policies. Another great example is dissolution—dissolving a New York not-for-profit corporation is a multistep task (one that, admittedly, was simplified by the recent New York Nonprofit Revitalization Act of 2013), involving the attorney general and the Department of Taxation and Finance in addition to the Department of State and any other state agencies with jurisdiction over the dissolving entity. In stark contrast, a nonprofit, nonstock Delaware corporation wishing to dissolve need only be up-to-date on its annual tax reports before the corporation may take a few relatively simple corporate actions to effect the dissolution. The time and cost difference between the two processes is remarkable.

Unless an organization must be a New York corporation for purposes of fundraising or interaction with New York-based institutions, there are very few reasons not to incorporate in Delaware. The main drawback is having to carry on two state compliance regimes, which primarily consists of filing the Delaware annual tax report and maintaining a corporate agent in Delaware (both of which carry a relatively small annual cost), in addition to filing the New York State registration and annual renewal. Delaware corporations also are required to have members, whereas New York charitable corporations are not (although other types of tax-exempt New York not-for-profit corporations do have to have members), but generally this does not impose a significant burden and can be satisfied by specifying in the bylaws that the board currently in place will serve as the members of the corporation.

A Word of Caution and Final Thoughts

A word to the wise: these advantages can cut both ways. For example, some complain that Delaware’s oversight of nonprofits is inadequate. The Delaware Attorney General’s Office Consumer Protection Unit is responsible for oversight of nonprofits and, although they are responsive, their oversight is complaint driven rather than active. Attempts have been made to pass a charitable solicitor registration act in Delaware, but it has not happened to date and is not on the horizon in the near future, the most recent bill having died in committee. On a more positive note, Delaware has mandated specific disclosure requirements for the solicitation of donations within the state: (1) the solicitor must identify themselves and the agency for which the funds are solicited; and (2) donors are entitled to question how the funds will be allocated between administrative costs and actual charitable use. Further, all state laws applicable to fraud and fraudulent transactions are required to be observed, and violations may result in civil or criminal prosecution. Another example of the need for caution is that the flexibility the Delaware statute, combined with the lack of active oversight, can have unintended consequences. For example, it can mean that a founder’s vision for a private foundation may be modified after his or her death or incapacity despite all intentions to the contrary. We have seen situations where, upon a founder’s death, the charitable purpose of a foundation was changed in ways that were technically legal, but not in keeping with its original intent and perhaps would not have been possible in a state with more restrictive governance and oversight, or given more foresight and awareness at the time of organization. Planning can mitigate this risk.

Cautionary tales have their place, but in many instances, the low administrative burden, lack of bureaucratic delay, ease of formation and amendment, flexible governance, and favorable tax treatment make Delaware an advantageous choice for nonprofit formation and one well worth considering.