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Cottage Food Act and Massachusetts: How can you start an artisan food business in your home kitchen?

Most of us either have that one secret recipe, or know a master home chef that has that amazing recipe, that everyone covets.  They are constantly being asked to bring that cake, guacamole, or in my case, grits to the parties and barbecues.  “This is so good, you should sell this!” is the frequent refrain until one day, you just have to take the plunge and try out your food passion as a business.  Massachusetts has a growing artisan community on all fronts, but especially food.  Our numerous farmer’s markets, specialty shops (both brick and mortar and online), and incubators are paving the way for local entrepreneurs to take their products to market and connect with consumers in new ways.

The idea of starting a food based business can seem a bit daunting, given all of the rules and regulations around food production, but Massachusetts has some great laws that allow you to start in your home kitchen and get a foothold in the marketplace.    Often referred to as Cottage Food Acts most states have legislation that allow for home cooking to be sold to consumers.

In Massachusetts, you can have a retail residential kitchen if you are selling your product directly to the consumer, for instance farmer’s markets, direct orders, consignment, etc.  If you are selling to retail stores and restaurants, you may qualify as a “Wholesale Operation”, which has a different set of rules.  Residential kitchens need to be inspected and you need to secure a permit.  The inspection and permitting process is conducted by your local town or city board of health and the permitting costs and inspection procedures vary from town to town, but are usually low cost and don’t require expensive alterations to your kitchen.  Things to think about are having a separate shelf or portion of a shelf in your refrigerator for storage of your business supplies.  Keep your cooking equipment clean (you can use your dishwasher).  Keep your pets out of the area while you are preparing foods for the business.  If your washer and dryer are in or near the kitchen, then don’t run them while you are preparing foods.  Be sure to contact your local board of health to get a full list of requirements.

The determining factor for whether you can use your home kitchen is whether you are producing non-potentially hazardous foods (non-PHFs) or potentially hazardous foods (PHF).  Non-PHFs are items such as jams and jellies, most baked goods, and confectioneries.  If your finished product does not require temperature control, then you are probably working with non-PHFs.

PHFs include products with meat, dairy, baked goods with cream, custard or puddings, cooked pasta, rice, or beans, eggs, fruits and veggies, and pickled products, sauces, and relishes that need refrigeration.   If your baked good uses dairy or fruits, but doesn’t require refrigeration once cooked, then it is likely going to be classified as a non-PHF.

So, we have a licensed residential kitchen creating non-PHFs for sale directly to the consumer.  There are still a few more requirements: 1. You have to comply with the state labeling requirements (see link below); 2. Only household members can be employees of the business; 3. You can’t use brokers, wholesalers, or a warehouse to store, sell, or distribute your product; and 4. You can’t sell your product out of state.  (For a full explanation of the rules, see the link below).

If you are creating a product that is considered to be a PHF or growing out of your home kitchen, you have options.  There are several communal commercial kitchens available in Massachusetts and more getting started each year.  These kitchens allow you to time-share the space, so that you get all the benefits of a commercial kitchen at a price that works for the entrepreneur.  Check out Crop Circle Kitchen.

Now you have an entity (always important), a license, and a permitted kitchen.  You are ready to sell.  Be sure to get acquainted with your local famer’s markets.  Pay special attention to Undiscovered Kitchen, a local business that is launching soon, creating a market place for artisan food products.  Be sure to review the additional information provided below.

Resources:

Residential Kitchen FAQs

Food Labeling FAQs

Starting a Wholesale Food Biz

Sam Adam’s Brewing the American Dream (great opportunity for education, support, and financing)

Jessica R. Manganello, Esq. is a business attorney with New Leaf Legal, LLC.  Her focus is on sustainable and social minded businesses, with a passion for food and building a local economy.

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Which Business Entity is right for you? (Part 1)

Which Entity is right for you? (Part 1)

C-Corp versus S-Corp

There are five main types of Business Structures: Sole Proprietorships, Partnerships, Limited Liability Companies, Corporations and Nonprofit Organizations.  Generally speaking, most businesses must choose between the corporation and limited liability company structures, because these are legal entities that have separate legal existence and therefore protect their owners from liability.

 

In this first blog, I will give you the pros and cons of the C-corp and information on the S-Corp election, so that you can make a more informed decision.  This explanation is by no means exhaustive, but should be a good base to start from.

 

Considerations

 

There are four issues you want to consider when choosing which entity type you want for your business:

  1. The type of members/owners and management styles available;
  2. The type of investment or capital requirements;
  3. The tax repercussions and statutory governance requirements associated with the entity; and
  4. The level of protection afforded to your personal property against liability.

 

The Corporation:

 

Governance

 

In a nutshell, the “corporation” or C-corp is a legal entity consisting of one or more owners.  The entity is established by filing Articles of Organization with the state and fulfilling the corporate governance requirements, including establishing a Board of Directors, and authorizing and issuing shares.  Most importantly is establishing a Shareholder Agreement and By-laws for the company.

The Shareholder Agreement lays out the rules, responsibilities, and obligations of each of the owners.  For instance, what happens if an owner wants to sell? If someone dies, gets divorced, retires? Who gets to decide if the company is going to sell assets or bring on new investment?  Most importantly what rights do the company and other shareholders have if an owner wants to sell their shares? The Shareholder Agreement is an operating manual for the company, so that no matter what curveballs business throws you, you have a mechanism for dealing with them fairly and effectively.

The Bylaws set out additional important (and statutorily required) information for the business, such as when you hold a shareholder or a director’s meeting and how you give notice to the shareholders.  How do you elect officers?

While this may seem a little onerous, especially when you are just starting out, these documents and following their policies play a very important role in maintaining the corporate form and keeping up the liability shields between the owners and the entity.

All corporations have Shareholders (owners), directors, officers, and employees.  These positions are established by the laws in the state where the corporation is incorporated and have the powers and rights provided for in those laws as well as the Bylaws.

A C-corp may have an unlimited number of Shareholders and may have multiple “classes” of shares, which means that each of the different classes created by the company have different voting and financial rights.

Taxation

The C-corp runs on a fiscal or calendar year as designated by the Board of Directors.  C-corps are subject to “double taxation,” which means that the revenue of the company is taxed at the corporate level and at corporate rates, and then taxed again at individual rates when distributed to the shareholders.  While generally dreaded, the double taxation structure allows a corporation to retain earnings (maintain a rainy day fund or cash on hand for budgetary expenses), without the tax liability for such funds being the responsibility of the owners.  Additionally, the corporate tax rates are often lower than the individual tax rates.  There are also some unique deductions that the c-corp benefits from.   The C-corp can further provide deductible fringe benefits to employees, as a result of this structure.

The C-corp given its ability to provide multiple classes of shares with different rights, offer stock option plans, and “go public”, make it an attractive structure for large scale investments and tends to be favored by VCs.

S-Corp Election

An “S Corporation” is the same as the C-corp.  It is formed the same way and has the same structure and governance requirements, but after forming, an S-election is filed with the IRS in order to change the tax treatment of the entity. This tax filing places some restrictions on the S-corp’s functioning, namely:

  1. An S-corp can only be formed by individuals (as opposed to another corporation or trust);
  2. All owners of an S-corp must be US citizens or permanent residents; and
  3. An S-corp may only have one class of shares (so no creativity with control and financial rights, everyone is treated the same).

The S-corp election must be filed within 75 days of incorporation and then must be re-filed every year in order to remain effective.  The election will stay in place as long as the filings are made on time and none of the above three restrictions are violated.  If for any reason they are, then the election is broken and the company will revert to a C-corp in terms of tax treatment and restrictions.  Be careful when breaking the election.  Once you do, you are restricted from pursuing S-corp status for five years.

So what does S-corp status do? It makes the corporation a pass through entity, so that there is no double taxation, but all revenues and losses pass through to the individual owners at their individual tax rates.  This can be advantageous at the beginning, where you have long term plans for which the C-corp is the best structure, but in the meantime would benefit from pass-through losses and the less tax resulting from the lack of double taxation.  Another benefit is that you can limit self employment tax if you are receiving a FMV salary from the business and the remaining profits are distributed as dividends.  This scenario is pretty individualized though, so see your accountant!

Quick Breakdown of Pros and Cons

 

C Corporation

Advantages:

  • Can have complex and creative ownership structures providing for divergences

in equity ownership of the corporation and operational control of the business, references to dividends or other payouts, different voting rights attributable to various classes of stock and Income splitting between owners.

  • Provides deductible fringe benefits for shareholders/employees, such as group term life

insurance plans up to $50,000; Medical reimbursement programs; and 100% medical and

disability insurance premiums. Fringe Benefit possibilities are more available and flexible

than in an S Corp.

  • Election of fiscal year.
  • In some cases, corporate tax rates are lower than individual tax rates.
  • Passive activity losses are deductible by C Corps under certain circumstances.
  • The ability to deduct up to 80% of dividends received.
  • The ability to use multiple Corporations.
  • Can use an employee stock ownership plan
  • Can go public.
  • Qualified Shareholders may exclude 50% of capital gains from the sale of C Corporation

stock.

 

Disadvantages:

  • Tax on corporate earnings applies at the Corporate level and then a second time when

Shareholders receive and report dividends.

  • IRS audits can result in the creation of constructive dividends for what the IRS considers

personal use of corporate assets.

  • C Corporations are subject to the Alternative Minimum Tax
  • C Corporations may be subject to the personal holding company tax or the accumulated

earnings tax.

  • The accrual method of accounting is generally required.
  • C Corporations generally have less flexibility than other business entities.

 

S Corporation

Advantages:

  • Income earned by an S Corporation is taxed only one time, at the Shareholder level.
  • Corporate losses pass through to the S Corporation Shareholder and are deductible at the

Shareholder level.

  • Passive S Corporation Shareholders can offset passive losses from other activities with their

S Corporate earnings.

  • S Corporations are not subject to the accumulated earnings tax, alternative minimum tax, nor

the personal holding tax.

  • Active S Corporation Shareholders are not subject to FICA tax on the S Corporation net

income.

  • S Corporation Shareholders who materially participate and have incurred debt to acquire the

stock of the corporation are able to deduct the interest expense as business interest.

 

Disadvantages:

  • Fiscal years must coincide with the calendar year, generally, limiting the opportunity to shift

income.

  • Potentially higher tax rates on certain levels of taxable income.
  • Fringe benefits received by Shareholders owning more than 2% of the corporation are

included in Shareholder income.

  • Dissident or new Shareholders can cause the termination of the S election through a

disqualified transfer of stock.

  • On formation, election must be filed timely (within 75 days) if to be in effect for the first

year of existence. Can be filed within 75 days of commencement of fiscal year for post

incorporation fiscal years but all stockholders must sign. Once election is revoked/lost, it

cannot be used again for 5 years.

  • Not a good structure if stock options are to be used for employee incentives.
  • S Corp cannot be a subsidiary of another Corporation.
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Which business entity is right for you, Part 2

Why the LLC Kicks Ass!!!!

(Which business entity is right for you, Part 2)

 

A “Limited Liability Company” (“LLC”) is a bit of a hybrid entity in that it allows for “pass through” taxation but offers the liability protection that is often the basis for creating an entity.  The LLC might actually offer more liability protection than a C-corp due to the fact that there are no built in fiduciary duties in an LLC.

LLC’s can accomplish all of the same functions, including holding property, owning subsidiaries, engaging in any type of business.  As a for-profit the LLC is still eligible for the same certifications and/or funding that a C-corp is.  The one thing to consider is whether or not your business plan includes Venture funding.  Most seed and angel organizations are comfortable with the LLC, but many venture funds like the C-corp.  This is mostly because of the board membership and various share type options.

One of the reasons that I love the LLC is that you can get creative with it and have multiple levels of management power, profit distributions, and voting power.  In the typical LLC, you have members (passive owners), managers (run the day to day and make most decisions), or managing members (they do both).  Managers make all the decisions except for the major ones requiring a member vote and profits/losses are distributed based on equity ownership.   This doesn’t have to be the case though.  You can customize your operating agreement to vary the amount of power the managers have versus the members.  You can have profit and loss allocations that differ from equity ownership, which is particularly helpful when someone is working in the business and someone else is not.  Just make sure you have a formula and justifiable reason for the discrepancy between profits/losses and ownership.  You don’t want an audit.

You can also create different classes of members.  So you can have voting and non-voting, managing and non-managing, or anything in between.  As long as the rights and responsibilities are spelt out in your operating agreement and not violating any state laws, you can run your business exactly as you would like to.

Additionally, an LLC’s yearly maintenance is relatively simple and does not require the same formalities as a Corporation.  You file your annual statement and keep good business records.  As opposed to the required annual board meetings and shareholder meetings, and the resolution drafting, etc. that is required by the C-corp, the LLC is very light on the corporate governance requirements.  This is especially beneficial when there is only one or a small number of owners and you have to send yourself a notice of the shareholder meeting, record that you showed up, what you discussed with yourself and what you decided to do. J

LLC’s are also useful to bring two or more business entities together for joint ventures.  If two businesses (LLCs or corporations) want to form a venture for a project or business, they can form an LLC as the joint venture to execute that particular project or business. This will allow profits and losses from the joint venture (the LLC) to flow directly to the respective entities, and at the same time can shield the owner/ entities and their other businesses from liabilities of the venture.

The majority of businesses are finding this to be the ideal structure due to the flexibility and low maintenance.  While the LLC is still considered to be a “new” entity, it has been widely adopted and in use for many years now, so most of the mystery has dissipated.  Most states allow a conversion from the LLC to a corporation in the event that need ever arises.

As a result of all the above (and below), I find that I am consistently recommending this entity type to the majority of my clients and that the LLC is capable of bending to meet their unique needs.  In short, well not quite, this blog is two pages long…..the LLC Kicks Ass!

Advantages:

  • An LLC can be treated as a partnership for tax purposes with the liability of the Member limited to his/her investment.
  • An LLC shields Members from personal liability.
  • The LLC is flexible. Contributing Members can make non-taxable contributions of appreciated property without regard to whether the contributing Members are in control and the LLC can make disproportionate distributions of money and property to its Members.  Profits, losses, voting rights and capital can be allocated in different ways among the members.
  • Potential avoidance of self employment taxes (if you are a completely passive owner).
  • An LLC is not required to hold Annual Shareholders/Directors meetings or comply with other corporate formalities.
  • Charging Order: If a person with an interest in an LLC is involved in a lawsuit and loses, the judge/jury may award damages to the other party. However, under most LLC statutes, all the creditor can recover against the Defendant’s interest in the LLC is a Charging Order. A Charging Order will give the creditor cash only when the LLC elects to distribute it.  The tax repercussions of a Charging Order make it unattractive as the creditor can be taxed on the income attributable to that share, even though no cash is distributed, and most attorneys will not have their customers accept such a lien.

 

Disadvantages:

  • Organizational and Operating requirements vary from state to state.
  • Some states impose higher filing fees and annual maintenance fees or income and franchise taxes than are imposed on Corporations. Also, state tax treatment may not follow federal tax treatment.
  • Members may not have limited liability in states that do not recognize Single Member LLC’s.
  • Due to the relative newness of LLCs, there is still a relative void of reliable case law and some unclear issues and variations between states as to treatment of LLCs, especially regarding creditors’ rights.

 

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L3C What?

L3C What?

The L3C or Low Profit Limited Liability Company is a relatively new form of the LLC (Limited Liability Company), that, for now, is only known about and talked about by its advocates, but is quickly spreading across the nation and becoming a revolutionary new way of doing business.

The L3C differs from the LLC in that the primary purpose of the L3C cannot be to make a profit, but rather the purpose of the business must be to achieve a social benefit, with profit as a secondary or ancillary purpose.  The name itself, Low Profit Limited Liability Company, is a bit of a misnomer.  The business is not restricted in how much profit it can make at all.  ‘Show me the Money’ just can’t be the number one goal.

“The L3C must be organized and operated at all times to satisfy the following requirements:

  1. The company must “significantly further the accomplishment of one or more charitable or educational purposes,” and would not have been formed but for its relationship to the accomplishment of such purpose(s);
  2. “No significant purpose of the company is the production of income or the appreciation of property” (though the company is permitted to earn a profit); and
  3. The company must not be organized “to accomplish any political or legislative purposes.” Wikipedia.com

On a practical level, the L3C does a few things for business owners.  It provides all the benefits of an LLC structure, including flexibility in ownership, management, decision making power, and profit distributions.  It is still a pass through entity for tax purposes and has very little ongoing administrative and corporate governance burdens.  For the socially minded business, in my previous post To B-Corp or not to B-Corp, I addressed how B-Corp certification provides credibility to a business as well as shields the management from shareholder lawsuits for making the sustainable or social decision as opposed to the most economic one.  The L3C provides both that credibility and liability protection for the owners and management, while leaving enforcement to the state and not subjecting the business to periodic audits by a third party.  Plus, great branding and marketing opportunities.

Additionally, and here is the best part…………..the L3C bridges that gap between non-profits and for profits.  Due to the restrictions on an L3C and the requirements for establishing one (see above), the L3C complies with the IRS rules for “Program Related Investments” (PRIs) and opens up possibilities for this additional source of financing.   PRIs are investments made by Private Foundations to for-profit ventures that are in furtherance of a charitable, educational, or religious activity.  They are generally high risk/low reward investments.  Many Private Foundations shy away from making significant PRIs because of the difficulty in verifying that the for-profit is using the funds in furtherance of an eligible activity.  Hmmmm written into the corporate charter and mandated by state law…………..problem solved!*

So here is an entity that solves a lot of problems existing as a result of there being no middle ground between the non-profit and for-profit entities.  Many non-profits spend more time asking for money than they do executing on their mission, due to the restrictions on revenue streams.  For-profits, due to shareholder interests and tax deduction restrictions, have been struggling with maintaining a social mission.  This is an entity that allows for investment and ownership, just as in a for-profit, but can also exist for charitable, educational, or religious purposes.  The L3C is that perfect gray area, middle child.

So why would a company find this model appealing?  Well it depends on what you are doing and what your mission is.  Social Entrepreneurship is on the rise across industries.  If your goal is an altruistic one, such as to produce low cost diagnosis and treatment methods for the medical field, increase consumer access and making them affordable solutions for developing countries, well then this may work for you.  Are you looking to build green communities? Are you the one laptop per child project? E-waste rehabilitation? Water purification?  The list can continue forever.  Whether or not the L3C is feasible or desirable for your company is all a matter of your mindset and ultimate goals.

For those businesses that do want to have a impact on the world 1st and make money 2nd, this structure gives you credibility, liability insulation, branding, access to PRIs as funding, and access to many government R&D grants that require you to be a for-profit entity.

As of now, the L3C is available in Vermont, Michigan, Illinois, Wyoming, Utah, The Crow Indian Nation, and the Oglala Sioux Tribe.  North Carolina, Maine, Louisiana and New York have passed legislation and will start registering L3C’s shortly.  Legislation for the L3C is under consideration in Colorado, Georgia, Oregon, North Dakota, Tennessee, and Montana.  Fingers Crossed!  I am hoping that Massachusetts will jump on board soon.  The L3C is spreading rapidly and entrepreneurs across industries are starting to explore the doors that it can open.

*The Down Side:  Of course, nothing is ever perfect.  For starters, the L3C limits you to an LLC structure and the equivalent for a C-corp is not around just yet.  There is no operating history for this entity, so the legal and tax repercussions are undetermined.  Most L3C statues allow the state to revoke your L3C status and convert you to an LLC if you don’t live up to your “primary purpose” or start focusing more on money than on mission, but how does the state know that? How does the state determine it? What exactly is involved with the conversion and is there shareholder (member) liability there?  This goes as well for the tax side of things.  While the IRS has issued a few non-binding opinion letters, nothing definitive has been said concerning whether investment in an L3C will qualify as a PRI.   Many attorneys don’t want to touch the structure because there are too many unknowns for their clients. I am one of those crazy early adopters that embrace taking calculated business risks and trying out the new toys. J  There are a growing number of us out there that see the potential and excited about these new opportunities for clients.

So bottom line, if you are socially minded, this could be a great entity for you, but tread carefully.

Another new development to watch out for is B-corp legislation, like that being considered in California.  Is there overlap and are we setting ourselves up for a B-corp versus L3C showdown?! Guess you will have to wait until next time to find out.  I know that you are just Dying!

 

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To B Corp or Not to B Corp

To B Corp or Not to B Corp

For those of you who are unfamiliar with B Corporations, B Corp is a certification designed by B Lab, a non-profit third party auditor.

“B Corporations are a new type of corporation which uses the power of business to solve social and environmental problems. B Corporations are unlike traditional responsible businesses because they:
· Meet comprehensive and transparent social and environmental performance standards.
· Institutionalize stakeholder interests.
· Build collective voice through the power of a unifying brand.” http://www.bcorporation.net/about

In order to be a B Corporation, a business must take social and environmental issues into consideration when making business decisions. This includes changing corporate governance language to require that these bottom lines are implemented.

What are the pros of B Corp?

1. If the mission and values of your business include an environmental and social bottom line, this certification allows you to cement those values into the culture of your business by changing your corporate governance documents in accordance with the legal language B Corp has developed. Which means if there is a change of the guard at your business, the new soldiers will be required to keep towing that party line. This also may prevent shareholder lawsuits in the event that a business decision is made that is better for the environment or society than shareholder bank accounts. Shareholders will know what the company stands for before they buy.

2. Great marketing tool. The B Corp logo has caught on with consumers in the LOHAS industry and is continuing to expand its. The organization provides you with digital logos, flyers, and poster boards with which to advertise your B Corp status. Your company will also be listed on their website as a member. This gives your business credibility, which let’s face it, in green, is sorely needed. With all the bogus certifications out there, consumers know that B Corp can be trusted and that a B Corp certified business has been thoroughly vetted.

3. Access to B Corp member resources and a growing community of business owners with the same priorities as yourself.

4. Charitable giving opportunities. You can either pay the B Corp yearly fee, or join 1% for the Planet. Tax deductions and more great marketing points. Why wouldn’t you?

5. Accountability. This is probably the largest benefit. Entrepreneurs and business owners know that as much as we love our companies, hard decisions must be made and stress wears us down. B Corp gives us built in requirements and standards, along with random audits lighting a fire under our bums, in order to keep us on the straight and narrow.

What are the cons of B Corp?

1. Application process is a bit daunting. Even the application for a small 0 to 10 person shop asks many questions surrounding policies, benefits, and pay that aren’t necessarily feasible for a small/growing company. Now there are many small businesses that are certified B Corps, so there must be discretion built into the application process that allows for start-ups. You may, however, be forced to develop policies that you aren’t “big” enough for, in order to meet their minimum requirements.

2. There is a fee.

3. Potential Marketing Disaster. As mentioned before, there are random audits of all member companies to ensure that they are staying true to the certification. This means, if you are not, you will lose your B Corp standing. If customers and affiliates have come to associate your company with the certification through the genius of your marketing efforts, its loss will be noticed and questioned.

4. Accountability. Both a pro and a con in my book. This is allowing an unvested third party organization to play some role in the operations of your business. What happens when your choice is between health benefits for your employees or more product development? How do you weigh these factors and how do you know if you are jeopardizing your B Corp status. In the end, you have to make the best decision for the longevity of the company and will you be too afraid of losing your status to make the right one? Could you also be setting yourself up for shareholder lawsuits, if your shareholders don’t think you gave enough consideration to environmental and social factors?

Of course to everything there is a laundry list of questions and concerns. In the end, you have to make the decision that benefits you and your business most. I am psyched about the B Corp certification (I am sure you couldn’t tell I have a bias). This certification provides manageable guidelines and requirements with teeth that give them credibility. Yes there is more administration and more to think about, but if you are running a company that is sustainable on all three bottom lines, it shouldn’t be a hindrance, more a stepping stool.

So go forth and B Corp.

Author: Jessica R. Manganello, Esq. New Leaf Legal, LLC; http://www.newleaflegal.com; @mangojess

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