(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. 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:

• She and her husband are both residents of the same state;

• She is in the non-resident state because her husband is serving in a non-resident state in compliance with military orders; and 

• 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.

(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.

Franchise Tax - Registering As A 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.”

For Example:

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. 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.

Let's Assume:

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.  

Assume Instead:

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, hop on over to our “Get Started” page.

(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.

Some 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

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. We have a whole post on that. 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.