What Business Entity is Best for Your Franchise Operation?

Whether you are a franchisee or a franchisor you need to determine the business entity you operate under.  The three basic choices for franchisees are sole proprietor, corporation (S or C), and limited liability company.  The two basic choices for franchisors are sole  corporation (S or C), and limited liability company ("LLC").  The S corporation operates as a pass-through and is not taxed at the corporate level, whereas the C corporation is taxed at the corporate level.  LLC's generally have the option to be taxed as a corporation or partnership (unless there is only one owner in which case it is taxed as a sole proprietor).

The choice of business entity involves both tax considerations and thus the need for an accountant to be involved in the decision process and management structure considerations and thus the need for an attorney.

Management: 

Corporations have an advantage from the management standpoint because their structure is defined by statute.  Thus, a corporation has shareholders, directors, officers and employees, a formula that has stood the test of time and is well understood by most business persons.  It does not have to define its own structure.  LLC's, on the other hand, are creatures both of statute and contract and, in their operating agreement, choose their management structure.  Creating a management structure is a burden and the choice can backfire.

Tax: 

LLC's were devised by lawyers, accountants and other professionals as a more flexible business entity than either partnerships or corporations.  For years, the LLC was the first choice of many.  Also, the LLC allowed profits and losses to be divided as the owners saw fit.  So, LLC's acting as partnership pass-throughs were often created.  But this flexibility ran straight into the brick wall of federal income taxation.  Business entities are income taxed at the federal level as partnerships or corporations.  There is no provision for LLC's.  So, LLC's taking advantage of the flexibility granted by state statutes often ran into a combination of tax and profit-sharing problems that defeated their purpose.  Today, the LLC is chosen more cautiously, and there must be a sound reason for the business to operate in that format.  

Even with their drawbacks, LLC's allow for partnership pass through taxation, which avoids potential double taxation that the C corporation has, and they allow for losses to pass through on a current tax year basis, which S corporations cannot do.  Tax laws do change, however, and C corporations and S corporations are more competitive with LLC's on a tax basis

Limited Liability: 

For smaller business and family owned businesses, this is often misunderstood.  Most states treat business entities as alter egos of their owners unless the ownership is more along the lines of a public corporation.  The real issue for the owners is which side of this line they are on.  For smaller concerns, insurance is an essential way to protect from personal liability.  This applies to both corporations and LLC's.

Going Public: 

For some business owners, this will be a factor in their choice of entity.

Family and Estate Considerations: 

This can be very complicated, but is an essential point to consider in entity formation.  Typically, though, corporate ownership can be perpetual, making it an estate asset, while LLC ownerhip cannot be perpetual, which creates a situation that must be dealt with upon death.

Cost: 

For smaller businesses, LLC's can prove to be more costly to maintain than corporations.  For franchisees, this factor can lead to the choice of sole proprietorship, which is the least costly.  And, LLC's and corporations can in multiple-owner situations be their own tax entity, requiring two sets of tax returns, corporate and personal.

The above is a brief outline of major factors.  The primary conclusion to be drawn is to be deliberate and cautious forming the business entity, and have professional guidance.

The time to obtain assistance in determining the business format is before forming the entity.  There is little room for error, and undoing error can cost more than doing it right in the first place.  Some aspects of business formation are a one-way street, so undoing the wrong choice can even result in paying unnecessary taxes.  Also, the state forms for some business forms are inadequate and their use can cause unintended problems.  Finally, to have your business entity accepted for what it is requires you to take all steps to operating that business as it should be.  For example, merely filing Articles of Incorporation for a corporation does not mean the business will be accepted as such.  

I generally charge modest fixed rates for business formations involving only a few shareholders and typical formation circumstances.  My usual rate in this regard is typically $650-$1300 depending on the complexity of the situation, including the filing fees and cost of obtaining share certificates and seal - these costs usually amount to about $125.  Extra services, such as shareholder agreements dealing with death, disability, etc., do add additional moderate costs.  I will tell you the actual fees applicable to your situation before you incur them.  I don't charge you fees until we are ready to begin, so you can call me at 303-740-2231 and go over the basics with me without concern over incurring a fee.  Also, if you want, you can Contact me by email from this Web site.