Incorporating in Delaware can reduce a firm’s tax burden significantly

Delaware is, as they say, winning.

Sixty percent of US public companies—and thousands of their subsidiaries—incorporate in the tiny state thanks to its business-friendly legal system and tax structure.

But just how favorable is the tax break? Incorporating subsidiaries in Delaware cuts a firm’s state tax burden by 40 percent, on average, according to a new study by Jacob Thornock, an assistant professor of accounting at the University of Washington Foster School of Business.

“By creating a subsidiary in Delaware and implementing a ‘holding company’ tax strategy, a firm can reduce its state effective tax rate by about two percentage points, from five to three,” Thornock says. “If you add that up over our sample, it’s around $60 billion dollars. That’s a lot of money saved.”

All in the family

Most of the academic interest in America’s business bastion has concerned the advantages of Delaware’s corporate legal environment, including a separate court system for business and predictable case law. Thornock’s study is the first to quantify the magnitude of the state’s renowned corporate tax loopholes that allow firms to protect income from its relatively high statutory tax rate.

Thornock, working with co-authors Scott Dyreng and Bradley Lindsey, examined the effective tax rates of a litany of large public firms and their subsidiaries headquartered in states that allow incorporation in another state.

“To accurately quantify this, you first need to understand the corporate family—the parent and all of its subsidiaries,” says Thornock.

That’s where the action, and much of the money, is. So while 60 percent of the Fortune 500 incorporate in Delaware, each firm in the study also has six or seven subsidiaries, on average—and as many as 700—in Delaware. Enron, for example, once had more than 500 subsidiaries incorporated in Delaware. And subsidiaries, not requiring the same legal protections as their parent companies, are most likely to choose Delaware primarily for tax savings.

Why Delaware?

Over the past century, the state of Delaware has gradually transformed itself into the nation’s onshore tax haven by building an incorporation economy of such scale as to be nearly impossible to compete against. It’s a volume business, and Delaware draws the lion’s share of volume.

With a population of less than 900,000 and stretching all of 96 miles at its longest point, Delaware is the state of incorporation for 52 percent of all subsidiaries in the study’s sample. To put that into perspective, California—with an economy that accounts for 40 percent of the nation’s GDP—is a distant second with six percent of subsidiaries. “Against all benchmarks,” Thornock says, “Delaware has an abnormally high number of subsidiaries.”

While those subsidiaries loophole their way out of paying much of the statutory tax rate, there are so many of them that the combined corporate taxes and franchise fees account for 20 percent of Delaware’s annual revenue.

So why don’t other states simply lower their corporate tax rate or introduce loopholes to take business away from Delaware? “The only reason that Delaware is making money is economies of scale,” Thornock says. “Everyone has declared them the winner for so long that few have even tried to compete.”

Diminishing effect

The tide is turning, however. Thornock’s study averaged the tax advantage enjoyed by parent firms and their subsidiaries incorporated in Delaware over the past 15 years. But if you look year-to-year over that same period, the relative tax advantage is dwindling.

As other states offer more competitive tax structures or prohibit out-of-state tax strategies, corporate money is increasingly staying in the state in which it is made.

“The Delaware savings is gradually diminishing,” Thornock says. “States are enacting laws that try to keep the tax base in the state. The playing field is beginning to level.”

Exploring the Role Delaware Plays as a Domestic Tax Haven,” is the work of Scott Dyreng of Duke University, Bradley P. Lindsey of North Carolina State University, and Jacob R. Thornock of the University of Washington Foster School of Business.