Make It Legal: Establish Your Business in 7 Easy Steps
DON’T LET THE GOVERNMENT, your health department, an insurance agent, a CPA or a family member get in the way of you launching your food business from the kitchen. Avoid letting self-doubt creep in or pangs of fear overwhelm you. You can do it. Thousands of other home cooks have.
We’ve broken this chapter into seven easy steps to get you going if you live in a state with a cottage food law on the books. While most states have start-up guides for a business, cottage food enterprises can avoid most of the red tape due to your size, lack of employees and limitation on sales.
But to run your business legally — which everyone should do — there are a few federal and state licenses you’ll need to get before you sell your first bagel. For a comprehensive list of the regulations, the Small Business Administration (sba.gov) provides an overview with detailed links to state-by-state requirements; go there only if you want to be overwhelmed.
Sure, the national statistic of failed businesses may be nine in ten, but as we pointed out previously, it’s practically impossible to fail with a home-based cottage food business since you’re starting it in your own kitchen with practically no start-up costs. Your only expenses may be a few licensing fees and the ingredients for the first batch of products you sell. This chapter covers the seven steps necessary to operate, legally, as a business.
Taking Exemptions
Here’s the great news. Unless you strike a gold mine with your food product and want to go big, below are some of the many regulatory EXEMPTIONS most cottage food enterprise owners can take, whether or not you’re a political libertarian:
• All employee and new hire state regulations. This assumes that you don’t hire employees and it’s just you in the kitchen, plus your spouse, a family member or kids pitching in from time to time.
• State unemployment insurance, especially in those states that restrict how much the business can gross, and therefore, how much an owner could earn and how often they might be in a position to actually pay themselves a salary.
• State worker’s compensation insurance, especially in those states that restrict how much the business can gross.
• USDA’s Food Safety Modernization Act, because of the products you’re allowed to sell under cottage food laws.
• Food and Drug Administration’s nutritional labeling, unless you explicitly make a health or nutrition claim or sell wholesale and/or in volumes that exceed their clearly defined exemptions. This exemption includes nutritional analysis and testing. Specifically, per the US FDA:
“One exemption, for low-volume products, applies if the person claiming the exemption employs fewer than an average of 100 full-time equivalent employees and fewer than 100,000 units of that product are sold in the United States in a 12-month period. To qualify for this exemption the person must file a notice annually with FDA…. If a person is not an importer, and has fewer than 10 full-time equivalent employees, that person does not have to file a notice for any food product with annual sales of fewer than 10,000 total units…. If any nutrient content claim (e.g., “sugar free”), health claim, or other nutrition information is provided on the label, or in labeling or advertising, the small business exemption is not applicable for a product.”
If in doubt, consult their website (fda.gov).
Some of the above exemptions are based on gross revenues earned, whether you have employees or not, and other variables particular to your state. Be sure to double-check that each of these exemptions applies to your situation
Step 1: Do a Local Zoning Check
Just because the state says you can operate a business from your kitchen doesn’t mean your county, township or municipality agrees, so check before you go to the next step. Zoning ordinances can be all over the board, vary from one county to the next and sometimes leave a lot of discretionary interpretive control to the administrator in charge. There may be restrictions on everything from the appearance of your home, use of signage or the volume of foot traffic by customers.
In your conversations or research of the zoning codes in states with more restrictive laws, it’s important to convey that you’re not starting a huge wholesale enterprise, just a small, direct-to-customer retail operation with a gross sales cap. If the concern is too much traffic at your house, offer to deliver your products to your customers. You may find that you need to bring the zoning administrator up to speed on what a cottage food law even is. If you’re in a state that allows wholesale and has no sales cap, just be open with respect to your plans and see what they say.
If you rent an apartment, live in a condo with a condo association or lease a home, you’ll also need to read the fine print in your lease or agreement and see if there’s anything explicitly preventing you from running a business out of your kitchen or your rented home. The same holds true if you happen to live in a planned residential neighborhood or complex; check with the homeowners’ association before you proceed.
In each scenario above, based on your research and to cover your bases, make sure you write down the specifics of any conversations that give you the green light, including the name of the person you talked with, when and exactly what was said. Try to get as much as you can in writing, since you can call upon this information later should an issue arise. E-mail works great for documentation if you choose to use this method of correspondence.
Step 2: Get Licensed by Your State’s Department of Agriculture
Contact the governmental office that deals with the cottage food law for your state, usually the department of agriculture, though the regulations vary a lot from state to state. Your state’s health department is not the administrative or regulatory body that licenses and enforces cottage food law; they handle restaurants, catering operations and other facilities where food is “prepared” and “served.” For a quick and updated reference, see our book’s website for the latest state-by-state cottage food developments and contact information.
In most cases, you’ll need to file for a “cottage food license,” occasionally called a “home food processor” license. A nominal fee may be charged in some cases. Some states will require an on-site inspection of your kitchen facilities while others call for some form of food-handling training. As covered previously, ServSafe Certification is one such online or classroom-based nationally accredited program set up by the National Restaurant Association; it’s often used by the restaurant industry to make sure their employees understand basic food safety practices for preparing and serving food.
Step 3: Set Up Your Business and Structure it Wisely
By now, you have a name for your business, plus another fictional name (i.e., doing business as or DBA), both covered in Chapter 4. Next is setting up your business. There are several ways to do so, addressed in more detail in our ECOpreneuring book. You’ll need to evaluate your own situation, your tolerance for risk and your business to determine which works best for you.
While cottage food entrepreneurs sell non-hazardous foods, there is a possibility that something might not be just right with your product, no fault of your own. Maybe one of your ingredients was mislabeled; perhaps a sliver of a nutshell found its way into the bag of walnuts you used for your granola. It happens. If a customer breaks a tooth or chokes on this shell, you could be held liable for damages. By operating as a corporation or LLC, you may be shielded from possible issues on a personal level.
Depending on your comfort level, you may be best off leaving the details and specifics of setting up your business to a certified public accountant (CPA) or a business attorney. While all business structures require governmental record-keeping and forms to be filed, corporations and limited liability companies (LLCs) involve additional legal and accounting requirements. That said, many cottage food operators we’ve interviewed have found the process straightforward enough that they did it themselves.
Below are several common business structures, broken down by the most recognized reason for choosing one over another: personal liability protection. This is a shield that prevents anyone with a court judgment or financial claims against the business to touch anything other than the assets of the corporation or LLC. In other words, certain business structures protect the personal assets of the officers, stockholders and employees of the business, reducing the risk that your house, personal property or bank accounts could be seized as a part of a court settlement.
No Personal Liability Protection
Sole Proprietorship
By far the most common, easiest and least costly business structure is a self-employed sole owner or sole proprietorship. Income from the business is reported as a part of the owner’s personal income using the IRS Schedule C or Schedule C-EZ; you may be subject to self-employment taxes of 15.3 percent. You are responsible for the liabilities and debts of the business. If your business is sued, everything you own could be threatened by the lawsuit.
General Partnership
If you go into business with a sibling or other family member, you would do so as a partnership instead of as a sole proprietor. When there are two or more individuals who are owners of a for-profit business, typically operating under a written partnership agreement, the business is a general partnership. All partners are responsible for the liabilities and debts of the business. Income is reported on the IRS Schedule K-1 and may be subject to 15.3 percent self-employment tax. The partnership must file an annual return, Form 1065, with the federal government and possibly a state return.
Distinct Legal Entity Offering Personal Liability Protection to Shareholders
S Corporation, or Sub-chapter S Corporation
Essentially a tax accounting classification, an S corporation is a common stock-issuing legal entity, income from which is taxed only once when it passes through to the employees or shareholders of the corporation on their personal income tax return. Like C corporations, discussed next, S corporations must file articles of incorporation, hold director and shareholder meetings, file an annual corporation tax return, keep corporate minutes and vote on corporate decisions. Most S corporations can use the more straightforward cash method of accounting whereby income is taxed when received and expenses are deductible when paid. Unlike C corporations, S corporations are limited in the number of shareholders they can have.
Officers, Shareholders and Taking Stock
Unlike a sole proprietorship, a corporation or LLC is a distinct legal entity, with a corporate formality that separates the owners of the company, the shareholders and its advisory body, the board of directors and its officers (president, secretary, treasurer) and managerial body, the chief executive officer (CEO) and the chief financial officer.
By law, a corporation must maintain a registered office and agent within the state where it is formed to respond to legal and official matters. If your corporation is in the same state as your residence, you can be your own resident agent. A one-person or family corporation must still follow the formality of corporate procedures related to decision-making and meetings. Document the “meeting” with corporate minutes, even if that means you write down your decisions if you’re the only board member as well as the CEO, president, secretary and treasurer in a one-person-owned corporation.
Ownership of the company is signified by receipt of stock certificates reflecting financial, property or service contributions to the business; shares can be voting or non-voting, common or preferred; the latter acts similarly to a bond in terms of its value. Shareholders taking stock usually have voting rights, financial distributions rights to dividends if declared by the board of directors and proportionate rights to assets should the corporation be dissolved.
The limited liability company (LLC) is a separate legal entity established by filing articles of LLC formulation or similar documents in the state where it is formed. The number of LLC members, various classes of stock and tax accounting selection determine a diversity of avenues to properly meet tax liabilities, whether the LLC is treated as a partnership or a C or S corporation.
Affordable Legal Documents
Some states have very straightforward forms that must be completed to set up small businesses as a corporation or LLC. Others, less so. Below are a couple of low-cost options to consider if you want to structure your business as either. Of course, if you tend to be risk adverse and have the funds, you may feel most comfortable hiring an attorney licensed in your state who specializes in small business legal issues.
• Nolo Press
One of the Internet’s leading websites offering free and easy-to-understand legal information and various do-it-yourself products.
• LegalZoom
For as little as $99, plus state fees, this online company can help you set up your enterprise as a LLC or subchapter S corporation in most states. It could be a source for other legal documents, too.
C Corporation
The most expensive and complex of business structures, the C corporation is a legal entity set up within a given state and owned by shareholders of its issued stock. It’s unlikely, due to the scale of your operation, that you’d form a C corporation — unless, of course, you strike it rich and turn your products into a full-blown big-time business, a possibility we cover in the Scaling Up section of this book.
The corporation, not the shareholders or directors, is responsible for the debt and liabilities of the C corporation. C corporations must file articles of incorporation, hold director and shareholder meetings, file an annual corporation tax return, keep corporate minutes and vote on corporate decisions. Income from C corporations, after expenses have been deducted, is taxed both at the corporate level and at the individual level, on wages and dividends paid to shareholders.
Regardless of the structure of your business, you will need to file some form of annual state and federal tax returns, using either the FEIN for your business or your social security number if you’re a sole proprietor.
Step 4: Secure a State Business License
The state in which you live wants to know if someone is operating a business there. For those of you who are merely diversifying your already established business by selling products through the cottage food law, you should have already completed this step.
For everyone else, you’ll need to contact your state’s department of revenue (or equivalent) to complete a simple application and pay a fee for the privilege of being in business for yourself. If your business is incorporated, a LLC, a partnership or a sole proprietorship operated under a fictitious or trade name (i.e, DBA, doing business as), there is a specific fee for your business license. If you operate as a sole proprietorship under your own name, you may not need to get a license. Verify what your state requires of you.
Federal Employer Identification Number (FEIN)
If you end up setting up a corporation, LLC or business partnership or find yourself hiring employees, you’ll need to get a federal employer identification number (FEIN) from the US Internal Revenue Service. You can apply for this number through the IRS on the Internet (irs.gov) or by filing the IRS form SS-4. The FEIN is sometimes referred to as an EIN, Employer Tax ID or a tax identification number or TIN; they’re the same thing.
Step 5: Get a State Sales Tax Permit
Now that you’re selling something to the public, your state’s department of revenue may require your business to collect sales tax on certain “value-added” products, like pickles or wedding cakes. To do so, you’ll need to get a sales tax permit and understand the state and, possibly, county and city taxes associated with every one of those 12-ounce packages of granola or gift tins of stollen that you sell at the Christkindlmarkt in December.
Heads up. In the government’s move to make everything electronic (except voting), many states are requiring Internet-based access and payment for related filings and fees. If you have little computer know-how, you may need to see if your local library can help you with this process.
Step 6: Get a Local Business License (If Needed)
On the local or municipal level, some cities or counties may require you to have a business license or tax certificate before you can operate. A call to your city or county’s clerk’s office will lay this one to rest.
Step 7: Manage Risk with Insurance
Living is risky business. Cars slide off the road after hitting a patch of ice, products stop working and bones break. When you go into business selling a food product, you’re accepting an additional amount of risk. You could be held liable for someone getting sick from eating your product, perhaps at no fault of your own. Today’s headlines are filled with outbreaks of E. coli-tainted vegetables and salmonella-laced peanut butter, largely a result of an increasingly industrialized food system. Major product recalls are about as regular as oil changes on your car.
Generally speaking, the cottage food industry is the antithesis of our industrial food system. It’s likely that you’re the only person preparing the entire order of marmalade or macaroons. You personally select each and every ingredient, knead and mince as needed, then bake, simmer or hot bath. You’re the one packing your product. Delivering it, too. Most of what you sell may travel less than twenty miles.
What we find in our supposedly “safe” supermarket travels thousands of miles, can be highly processed and is filled with artificial ingredients and preservatives thanks to the magic of modern chemistry. But the ingredients listed on your package can be pronounced; they’re real, minimally processed and made locally.
If you scale up and sell wholesale to regional grocery stores or a national specialty food chain, it’s different, covered in greater detail in the Scaling Up section. You may even be required to have a “recall” plan in place for your product. Plus, once your product is out of your hands, you don’t have control over how the distributor or retailer handles it, spawning the growth of “tamper-proof” packaging.
What if your product gets left in a distribution truck that breaks down in the desert for two days? What if a retailer decides to display your preserves in direct sunlight in a south-facing front window? Of course, you would want to avoid such extreme heat or sunlight conditions on your products. But what if? That’s what insurance is for: covering you for accidents, the unknown or situations beyond your control.
Regardless of your approach to your ingredients, products, customers and scale of operations, there’s always a possibility something may not go exactly as planned. In response to our litigious society, insurance has become a necessary part of both living and doing business.
What you need to evaluate is your appetite for risk and the insurance requirements related to what you want to do with your business. You should start by checking if you are already covered in some way, either through your existing homeowner’s insurance or in how you structure your business (covered in Step 3 of this chapter). To manage risk, consider combining insurance with other strategies. Of course, your “non-hazardous” products themselves are another way you reduce your risk exposure.
If you’re already in business, then you’re probably already covered at some level for food or personal liability issues. In most cases, it’s nothing more than checking with your insurance company.
For example, for our small B&B (and cottage food enterprise), we have the business specifically listed on our homeowner’s insurance policy as a rider; the annual premium is less than $100 and provides $300,000 of personal liability coverage. Our business is viewed as “incidental to the home” by our insurer, Cincinnati Insurance Company. Additionally, we have a $1 million umbrella insurance policy that covers anything we do on our property and in our car, above and beyond the $300,000 coverage. Everything changes should we decide at some point to prepare food products in a rented commercial kitchen; at that point, we’d need to purchase a commercial business liability policy that may run, at minimum, over $500 per year.
If you’re just hanging out your shingle, you’ll need to explore with an insurance company what level and type of coverage might be needed for you to feel comfortable and sleep well at night. The annual premium for your business and product liability coverage will depend on the level of coverage, sales venue, gross sales volume and, of course, your products themselves. In many cases, a commercial insurance policy will be required not for your state, but for the venues where you sell your products. Many sales venues require a “certificate of insurance” for an amount ranging from $300,000 to $1 million; this certificate, generated by your agent based on your policy, explicitly refers to the venue by name.
In response to the growing number of businesses and sole proprietorships in the food industry, Utah-based Veracity Insurance Solutions offers a Food Liability Insurance Program (fliprogram.com) with an annual premium that starts at less than $300. At this rate, the company offers a general liability policy limited to $2 million.
As discussed previously, structuring your business from the start as a corporation or LLC offers a liability benefit but comes at a cost and with more complicated paperwork. Maintaining adequate insurance coverage would add to your protection.
The challenge remains finding a balance between the joy and financial benefits of operating a food-based enterprise and managing some of the risks associated with doing so. In the end, it’s your decision. But keep in mind that, in nearly all cases, cottage food laws by their very definition apply to non-hazardous food products. Enough said.
“Starting a cottage food operation has huge legal ramifications, and cottage food laws accidentally make people think they are shielded from rules and regulations. I have concerns about whether cottage foods actually increase potential liability and about the insure-ability of the operations. I’ve heard of folks getting dropped by insurance companies or trouble finding an affordable quote. This has to do with insurance agents not fully understanding what these laws entail and the small scale that we’re talking about. Many are going without insurance at all. The state laws authorize you to sell certain foods but do not cover nor exempt you from liability issues.”
— RACHEL ARMSTRONG, AN ATTORNEY AND EXECUTIVE DIRECTOR OF FARM COMMONS (FARMCOMMONS.ORG), PROVIDING LEGAL EDUCATION FOR THE SUSTAINABLE AGRICULTURE COMMUNITY. CHECK OUT THE FARM COMMONS WEBSITE FOR VARIOUS FREE WEBINARS AND RESOURCES THAT DIAL DEEPER INTO LEGAL ISSUES RELATED TO VALUE-ADDED PRODUCTS.