Answers to 6 Key Legal & Tax Questions for Military Spouse Small Business Owners
During tax season, I often get questions on state tax issues from those in the military. Traveling from place-to-place presents unique tax issues, particularly for service members and their families. Due to the nature of travel involved, I have met many military spouses who have their own businesses. You may fit into this category. If you do, you understand that move from place-to-place as a small business owner presents legal questions that go beyond taxes. My goal for this post is to provide guidance on some of the most frequently asked questions from military spouse businesses owners regarding how to handle the legal and tax aspects of their business.
I know this post is a bit lengthy, but it’s important stuff, so pour a glass of wine, check on the kids or pets, grab a snack, and buckle in.
If you think I skipped over a common issue for military spouse business owners, please let me know in the comments. I plan to supplement this post as necessary.
Understanding Some Basics
Before we dive into the specifics, it’s important to understand some fundamental concepts.
Common questions involve how to handle LLCs and Corporations and where to form them. Most of my client from Braden Drake Law and here at Creativepreneur Consulting operated as either sole proprietors or LLCs, so my focus here is on tips for these individuals. However, most of the principals will be the same for C Corporations. If you’re relatively new to these concepts, I encourage you to read this blog post on the topic.
Franchise Tax Versus Income Tax
Income tax is the tax that we’re mostly aware of.It’s based on our income. Franchise tax is a privilege tax that most states require annually to operate an LLC, S Corp, or C Corp. I like tell my clients that it’s easiest to think of the franchise tax as an annual fee for operating your business entity. Some states have different names for this tax and the amount varies. Some states have no franchise tax. In some states the tax is $200. In California, the annual franchise tax is $800. Sole proprietorship and general partnership do not pay franchise tax. This annual cost is one of the primary considerations individuals think about before forming their LLC.
Ok, so we knocked out the introductory concepts. Let’s go straight into the FAQs.
I’m going to assume that you are U.S. Citizens or a U.S. resident for tax purposes subject to federal taxes on all income. As such, oweing federal taxes is a given - unless you’re stationed abroad for some time - as such this article will specifically be discussing state taxes. The key concept for determining state tax liability is tax residency. Generally, U.S. persons are residents, for tax purposes, of the state in which they’re domiciled. Domicile is a loaded term with many rules. We’re going to skip over those, for now, and focus on military residency.
Each military service member has a home of record, which is typically the home state of the individual when he joins the military. The service member then has a state of legal residency (SLR), which makes that state the person’s domicile for tax purposes. Typically, the SLR is the same as the home of record unless the individual files a DD Form 2058 to change the SLR. Different rules apply to spouses of military service members. The Military Spouse Residency Relief Act (MSRRA) provides special rules for tax residency.
The MSRRA helps military spouses overcome the general rules that require a civilian’s residency for tax purposes to change as she moves from state-to-state. Instead, the MSRRA allows military spouses to maintain the same state of residency as the service member under particular circumstances. First, the spouse must establish the state as their domicile. Then, the spouse must maintain that state of domicile. This is trickier than the rules placed on the service member.
Under the law, we look at a person’s intent to determine where she is domiciled. From there, we can judge different pieces of evidence to prove that intent. We will look at a concrete example in Question 1.
(1) How do I Know Where to Pay My Business Taxes?
We pay individual income taxes based on where we perform services, not based on where our business is formed. State of formation only impacts corporate taxes, franchise taxes, and other business taxes. If you own a single-member LLC, sole proprietorship, or S Corp, your business income passes through to your personal tax return, and you will typically pay based on where you are performing services. (if this is all gibberish to you, read my blog on business entities and taxes). For military spouses, the MSRRA provides an exception for this.
Let’s look at an example.
Carol has her own copywriting business. She has not filed any paper work for a formal entity, so she currently has a sole proprietorship. She and her husband are from Texas. Carol’s husband is in the navy. He comes home one day and tells Carol that they are being relocated to be stationed in San Diego. Carol knows that their new home is likely temporary and regardless of where they are stationed next, after San Diego, she and her husband intend to go back to Texas.
In this example, Texas is Carol’s domicile, because it was established as her domicile before she moved. In order to maintain that domicile, she needs to consider showing her intent for Texas to remain the domicile. Carol should keep her voter registration in Texas, keep a Texas driver’s license, if her new state allows this, and keep whatever other attachments she has to the state.
If Carol’s husband were a civilian and they moved to California for his new corporate job, Carol would need to file taxes in California and pay taxes to the state based on the services she performed while living in the state. BUT, as military spouse, the MSRRA allows Carol to overcome this default rule and only file and pay taxes back home in Texas if she meets the following factors:
(1) She and her husband are both residents of the same state;
(2) She is in the non-resident state because her husband is serving in a non-resident state in compliance with military orders; and
(3) She is residing in the same non-resident state solely to be with her husband.
All that stuff about keeping ties to Texas, like the drivers license, is how Carol meets part 1 of this test. If she also meets prongs 2 and 3, then she can file her tax return as if she were still a resident of Texas. For Carol, the MSRRA is a huge benefit because Texas does not have state income tax. If Carol were from California and moving to a lower tax state, she may not want to use the benefits provided by the MSRRA.
Make sure, come tax time, that you seek out someone experienced with these rules to assist in preparing your taxes. I offer different options to help get taxes done. If interested, you can view those here.
(2) In Which State Should Military Spouses Form Their Businesses?
if you already formed in one state and have questions on moving, I cover that here also.
Some individuals choose to form businesses in specific states for legal liability reasons. Some states are more friendly to “big business.” Some states also allow greater degrees of confidentiality with regard to who owns stake in a company. Most of my clients are serviced based, creative entrepreneurs, and these three factors do not weigh heavily in their decision making. Therefore, I will focus on the tax outcomes of forming in particular states.
The state of your business’s formation is irrelevant for income tax purposes. Income taxes are determined based on individual residency (look back to all question 1). For example, if Carol had formed her LLC in Nevada, but her domicile is Texas and she currently is stationed in California, the fact that her LLC is formed in Nevada has zero impact on her personal income tax return. This rules out income tax as a factor in deciding where Carol needs to form her business. Since she is likely unconcerned with confidentiality and business laws in each state, the remaining factors to consider are convenience and franchise tax.
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Franchise tax – register foreign LLC
I noted above that each state has different rules regarding franchise tax; some states have no franchise tax. I speak with many new business owners who decide to simply form their business in a state with no franchise tax. To them, this seems like a great idea. What they’re neglecting to consider is that most states require individuals to register their already formed LLC in the state in which they’re operating as a “foreign corporation.”
let’s look at Carol again. Let’s assume she decided to no longer be a sole prop, so she forms her LLC in Delaware sometime before she moves from Texas to California. If she is now performing services in California, she will need to register her LLC in California. (Note that all states have different rules – as a CA attorney, I can only speak to the precise rules in CA). The state calls LLCs formed outside the state a “foreign LLC,” so she would register her LLC as a foreign LLC with the state. When you register a foreign LLC, you pay the same annual franchise tax as you would have had you originally formed in that state.
Ok, so Carol, now has to pay California franchise tax. She also has to pay any franchise tax imposed by Delaware. For this reason, I typically suggest non-military business owners to simply form their LLC in their home state where they are working. Obviously, if you’re moving from place-to-place the considerations are a bit different.
So now we have enough information to finally consider the question posed above. Where Should Military Spouses Form Their Businesses?
If the military spouse meets the MSRRA elements to claim the same domicile as the service member spouse, it would likely make the most sense to form the LLC in the state of domicile because having the business formed in that state provides further evidence that the state is their domicile. It’s one extra factor to pile onto that list that you intend to be a residency of a particular state.
You may now be asking “but what about if I can’t claim the same domicile as my spouse.” What if that MSRRA stuff doesn’t apply to me?
In this circumstance, we need to consider a couple more legalities.
Above, we covered registering a foreign LLC. When moving a to a new state there are a couple of alternative ways to take your LLC with you. The first is to dissolve the LLC and reform it in your new state. The second alternative is to “domesticate” the LLC. Think of this as a transfer. Domestication allows you to keep your businesses EIN while transferring your LLC from one state to another. Not every state allows this, but it can be a worthwhile option if you plan to be in your new state long enough to make it worth the hassle.
Carol never establishes her domicile in the same state as her husband. She was finishing school in Florida while her husband was in Texas. Carol’s husband gets stationed in California. She moves to California, they get married, and live there for two years. The couple then moves to Virginia. If Carol formed her LLC in Florida, she would have a few options both times she moved. Unlike many states, Florida has no franchise tax. Therefore, she may as well just register as a foreign LLC in California and then in Virginia. There’s no benefit to dissolving the LLC and reforming or domesticating since it costs her nothing to keep the LLC in Florida.
that Carol formed her LLC in Louisiana. The base franchise tax in that state is only $110. Domesticating the LLC into California requires a $70 filing fee. Carol might decide it’s not worth the hassle to domesticate the LLC in California, so she registers as a foreign LLC.
Looking at one last example,
assume Carol forms her LLC in California while she’s living there. Once she moves, it will likely be worth her time to domesticate or reform her corporation in her new state to save the $800 annual franchise tax.
We could look at many examples, but as you have likely seen the best way to structure your business will be based on your individual circumstances. Therefore, you simply need to know which obligations each state has, how your residency and domicile is going to operate, and then gather all of the information and work out the puzzle.
The good news is that state of incorporations does not have wide spread effects, so it’s not worth a ton of stress. However, you can save some stress and money if you take some time up front to plan.
You can always schedule a consultation with an attorney as well. I offer one hour consultations to help sort through these issues with my clients. If you’re interested in chatting, submit a form on my law firm contact page to get started.
(3) Should I Consider Sales Tax and Tax Rules Regarding Digital Products When I Decide Where to Form My Biz Entity?
In short, no. Sales tax has its own rules, and, of course, each state is different. The rules depend on where the purchaser of the item subject to the sales tax is located. The state of incorporation has no effect on these taxes.
Have some more specific questions on sales tax for creativepreneurs?
I have a free download on what you need to know about sales tax as a creative small biz.
Some More Basics
I went ahead and started answering the remaining three questions and realized that maybe I needed to back up and add this bit.
Federalism - State Versus Federal Law
Now, we’re flashing back to our civics classes. The U.S. has a federalist system of government. This means that governmental powers are divided between the state and federal governments. We have both federal and state laws. I won’t bore you with a whole course on Constitutional law, but the key here is simply knowing that some laws pertinent to small businesses are federal laws. Therefore, your state of residence or state of incorporation is irrelevant. Our legal system reserves other powers for states, so some other bodies of law that impact small businesses are governed by state law and, therefore, the rules are different depending on where you operate or are formed.
Common Law Versus Statutory Law
Laws come about primarily via two pathways. The U.S. federal law is largely a common law system as is all the states except for Louisiana. Common law means that the law is provided through court cases. Consider Roe v. Wade, likely the most widely known court case. That was a case heard by the Supreme Court which changed the nation’s laws. New cases are continually supplementing and creating changes to the rules provided in that case. We have both state courts that create state specific common law and federal courts that create federal common law.
Statutory law is provided by legislatures. Prime examples include the Affordable Care Act (“Obamacare”) and the Tax Cut and Jobs Act – this is the new tax passed by Congress a the end of 2017.
Independent Contractor versus Employee
Here, I’m not going to get into the legal/technical difference between these individuals. Rather, I just want to note that when I refer to independent contractors, I’m referencing someone who is not on your payroll. Some states have strict employment laws that provide specific benefits to employees. This is why it’s important to properly classify workers as either contractors or employees and to properly refer to those works in legal documents based on their classifications.
(4) Does State of Incorporation Impact Hiring?
This is kind of a tricky one. The short answer is no. There are both state and federal employment laws. Employment law also stems from both case law and statutory law, which means that both political shifts and new case law can reshape the rules. Federal laws will apply regardless of the state of incorporation. State laws apply, not where your business is incorporated, but rather when the workers are located.
For example, I used to work at West Elm, which is owned by Williams Sonoma, Inc. The corporation was formed in Delaware, but the company had to pay me based California minimum wage, a state law, because I, the worker, was in California.
Whether you are hiring independent contractors or employees, the key is to be familiar with the laws in those states where the worker is performing services for your business.
Note, that in California we have some very specific rules. Specifically, new case law put a wrinkle in the legal question determining whether a worker is an employee or independent contractor requiring more workers to be reclassified as employees. I have a comprehensive article on this new topic. If you have questions, make sure to check that out by signing up for my legal freebies
(5) Are There Any Specifics We Need to Know About Regarding Our Client Contracts?
We’re not going to get into all the elements of a contract and precisely what needs to be them. Instead, I’m going to focus on a common question for military spouses. Recently, I was asked what state a military spouse small business owner should designate as the state where litigation would occur if they were sued. That business owner also asked if state of residency or state of LLC formation had any effect.
Generally, lawsuits against you or your business can be brought in the courts of the state where the injury/disputed event occurred, where you reside, and/or where your business operates. However, you can specify in a contract where a person must sue you if there is a dispute in regard to the contract. This is done through a “forum selection clause.” You are choosing where it is that you must be sued in the case of a dispute.
There are a few factors to consider when deciding what venue you should use. The most obvious factor is convenience. I recently spoke with an individual in California who signed a contract with a venue provision that specified that disputes must be handled in Indiana. The individual wished to file a small claims suit against someone who owes her around $8,000. To do this, she must now file that suit in Indiana and go there, should the suit make it to a small claims hearing.
Obviously, we all hope to never need this provision, but it’s a good idea to add the extra couple of sentences into your contract. Most often small business owners will choose the forum based on where they live. This is the tricky part for military spouse business owners who frequently moved.
There are a couple of options. One option could be that specify that a person suing you must file suit in the state where you are residing at the time they choose to bring the lawsuit. That way, if you move after forming the contract, they must come to you. The laws around choice of forum are complex and vary based on state and federal courts. This type of provision may or may not be enforceable depending on the circumstances.
The alternative, and the most common option, is to specify the forum based on where the contract is formed or where the services are formed. This type of provision is largely allowed.
If you have questions on your contract, feel free to shoot me an email or a phone call. I provide contract reviews for many of my clients. You can find my contact information here.
(6) What Do I Need to Know Specific to Trademarks?
Trademarks are an issue of federal law. Registering a trademark gives you protection all over the U.S. If you do not register your trademark through the United States Patent and Trademark Office, you may still have protection under common law trademark laws, which do vary state-by-state. Since trademarks are largely a federal issue, there is really nothing to be concerned of specifically with regard to military spouses.
Although, there are no unique trademark considerations, there may be some unique issues regarding initially choosing a business name. You cannot choose an LLC name if it’s already taken in the state where you wish to form. Thus, think ahead of where you wish to form your business and do a name search. There’s also the option to have a DBA (doing business as). However, you will still need to make sure the name does not conflict with others in the geographic area you plan to operate. If you have more questions on choosing a business name, I also have a blog on that.
If you’re looking for trademark help, I do assist with these in my law firm. You can check out rates here.
The U.S. legal system is a complicated one. It can be frustrating, but I always try to bear in mind that our system is complicated because of check and balances, state rights to make their own laws, and other protections provided by our Constitution. Being a military spouse business owner certainly poses an extra layer of complication with regard to legal and tax questions. Hopefully, I was able to address some of those here. If you have any questions, feel free to post them below.