I am starting up a small business software company with a friend who happens to live in another state (I am in MA, he is in IL). We are planning on creating an LLC for liability protection, and are trying to figure out where to incorporate and whether we need to register as a foreign corporation in the other state (or if we should incorporate in some neutral state, such as Delaware). We will have no office, but both be working out of our home doing software consulting that we find through online marketing, while working on a software product.
There is little reason to choose a third state in which to form your LLC, because you will have to register (and pay annual fees) in the state(s) where you are doing business, in addition to the third state.
So you should form the LLC in MA or IL.
I don't know what the standard is for "doing business" - and thus needing to register as a foreign entity - in those states. In CA, it is "entering into repeated and successive transactions of its business in this state, other than interstate or foreign commerce".
Disclaimer: This post does not constitute legal advice and does not establish an attorney-client relationship.
Some folks on this site will recommend you register in Delaware, but in my opinion that's rarely the best option for startups. If you incorporate in a state other than your home state, you will have to register the LLC as a foreign entity in your home state. Registering as a foreign entity means that you will be required to pay the state fees every year. In your case, you will have to register as a foreign entity in at least one state because you will be doing business in two states. But if you register in Delaware (or any other state), you will have to register as a foreign entity in two states (MA and IL). IMO, the money you may save in taxes by registering in Delaware doesn't offset the money you will have to pay the states as a foreign entity.
Another thing to consider is the tax structure of your LLC. Will your LLC be taxed like a partnership or a C-Corp? With partnership taxation (pass through taxation), the profits and losses of the business will pass through to you as the owner. This means that you will have to pay state income taxes on the profits in the same way you would if the LLC were regsitered in your home state.
If you go with corporate taxation, the LLC pays income taxes according to the rules of the state it is incorporated in, and you as the owner will only pay income taxes on the portion you take out according to your state's rules.
My advice would be to keep things simple and register the LLC in either MA or IL. You will still have to register the LLC in the other state as a foreign entity, but it saves you the work and hassle of also registering in Delaware.
Also, if you haven't already, check out these other related questions previously asked on this site: