Business entities are generally formed state-by-state. While this separatist approach has many shortcomings, scholars and policymakers have considered only one alternative: the federalization of business entity formation. Yet limiting the choices to two is false and distortive. It is false because another alternative – multistate formation and regulation of business – is possible. It is distortive because it deprives policymakers of the advantages of multistate corporations and other business entities. In a new article, we show that multistate business entities are, in fact, preferable to both state separatism and federalization.

Background on the Market for Entity Formation

When entrepreneurs (or their investors) choose the state in which they want to form their business, they provide that state with franchise taxes and other benefits.  In return, the state provides the entrepreneurs (or their investors) legal benefits that include limited liability, anonymity, and pass-through taxation.

This beneficial exchange between states and entrepreneurs created a competition among states for companies. The outright winner is, of course, Delaware, where the vast majority of U.S. publicly traded corporations, as well as many private corporations and LLCs, were formed.  Other states that have, at least recently, been able to attract significant numbers of companies include Nevada and Wyoming.

The impact of this interstate rivalry is a matter of great debate. Many scholars and policymakers have described the interstate race for companies as a race to the top or the bottom. Either way, the competition is not carried out in a vacuum, and the federalization of business entities law significantly affects the formation and governance of firms. Whether that is a good or a bad thing is highly contested, but our article questions the very framing of the debate.

Multistate Entity Formation Is an Overlooked Regulatory Option

Enter multistate agreements. The Compact Clause of the United States Constitution allows states to cooperate in many contexts, both with and without the federal government’s involvement.  First, it leaves many multistate agreements outside the purview of the federal government.  Second, and as important, it allows states to bind one another with long-term commitments backed by the authority of Congress.  Multistate agreements are not just constitutionally permitted, they have also been a source of great collaborative benefits. Notable collaborations run the gamut from environmental initiatives such as the tri-state environmental commission (New York, New Jersey, and Connecticut) to transportation initiatives such as the Kansas City Area Transportation Authority (Missouri and Kansas).  We show that the regulation of business entities can and should be the next frontier of multistate cooperation.

Why We Need the Multistate Entity Formation Option

Allowing firms to be formed in a multistate regime would be highly beneficial to the participating states, the firms themselves, and the various stakeholders of the states. Consider the benefits that could be generated if the “rust-belt states” – states that rely most heavily on manufacturing – formed a multistate business entities regime.  Such a regime would allow them to form a competitive coalition that could produce significant revenues from franchise taxes and other formation benefits. It could also provide firms with the ability to exchange the difficulty of dealing with different laws in neighboring states for a streamlined and single body of business entities and tax law that suits their needs. Finally, this regime could capitalize on its expanded regulatory powers to better protect stakeholders such as workers, the environment, and local communities.

1. The Business Law Reasons

A multistate regime would have administrative and legislative benefits. The administrative benefits would include the ability to form multistate tribunals and centralized filing and compliance centers and streamline the conduct of a multistate business by eliminating the need to file and pay for foreign qualifications or for the formation of subsidiaries. The legislative benefits would include the bundling of the various state options for types of business entities.  For example, if state X allows an entity to maintain the anonymity of its equity owners, but state Y does not, the collaboration between the states would allow firms to choose the anonymity feature without emigrating from their formation domicile. Each state’s lawmakers and judges would no longer need to engage in costly and time-consuming debates over what options to allow. In addition, a multistate regime would promote consistent and predictable legal treatment across various jurisdictions. Other stakeholders would also benefit. Since the states would be providing firms with enhanced benefits, they would be better able to enforce meaningful and expensive stakeholder initiatives. This is so because the higher the cost savings the states can provide firms, the more the states can pay for stakeholder initiatives while still netting a result that is more profitable than the alternatives.

2. The Tax Law Benefits

A multistate business entities regime could also produce multiple tax law benefits.  The administrative and legislative tax benefits are compounded because participating states can coordinate across many tax regimes, including corporate income, personal income, payroll, and sales and use.  Importantly, states could incorporate any level of tax cooperation into a multistate regime. The tax law benefits augment the business entities law benefits, but states may forgo tax law cooperation if it is not politically viable.

Many of the administrative tax law advantages mirror the administrative business-entities law benefits.  These benefits include the ability to form multistate tax tribunals and centralized filing and compliance arrangements that will reduce administrative costs and enforcement burdens.

The legislative, or tax policy, benefits of a multistate business entities system are extensive as well.  Cooperation and uniformity can greatly increase efficiency in all aspects of lawmaking—legislative, administrative, and judicial. More significant, however, is that participating states can adopt tax policy approaches that allow them to compete together rather than individually against other states. Because migration between states is relatively easy, state tax policies often yield a race to the bottom that results in loss of revenue.  If states join together, they can create tax laws that are suited to the states’ specific circumstances and prevent cross-border cannibalization.  For example, states in the “rust belt” could incorporate into their tax laws certain benefits for their manufacturing and industrial constituents, such as single-sales factor apportionment and unified credits and incentives for job creation.

A multistate business entity regime would improve the market for business entities, as it would become more competitive and in the process benefit investors, entrepreneurs, and society.  Our hope for the future is that legislatures consider this regulatory path seriously.

This post comes to us from professors Andrew Appleby and Tomer Stein at Stetson University College of Law. It is based on their recent paper, “Multistate Business Entities,” forthcoming in the Arizona State Law Journal and available here.