Congratulations! You’ve made the decision to start your first franchise, and you can’t wait to get started.
It’s one thing to decide that a franchise is the best way to be an entrepreneur. Deciding how to set up your new business is another question altogether. What options do franchise owners have to set up their business, and which one is best?
There are three common types of franchise business structures: sole proprietorships, LLCs and corporations. How are they set up, how are they taxed, and which one has the structure that’s best for your franchise?
What is a Franchise Sole Proprietorship?
A sole proprietorship, which is also known as a sole trader, is a type of business that has a single owner: you. They are by far the simplest and quickest types of businesses to set up, and many successful new franchises start out as sole proprietorships.
How is a Franchise Sole Proprietorship Set Up?
Unlike other types of business entities, sole proprietorships don’t have to be formally registered with the state. However, you do have to apply for an employer identification number (EIN), which will allow you to open a business bank account, apply for business permits, get business insurance, enter into franchise contracts, and give your company official recognition for tax and legal purposes.
As the only owner of a sole proprietorship, you are always in total control over how your company operates and conducts business (within the limits of your franchise agreement, of course).
How are Franchise Sole Proprietorships Taxed?
Sole proprietorships are “pass-through” entities, which means that you’ll file any company profits and losses in your personal tax return. On the one hand, sole proprietorships are much simpler when it comes to taxes, but the trade-off is that you won’t be able to take advantage of lower tax rates enjoyed by other types of business structures.
If you start out your franchise as a sole proprietorship, keep in mind that all that personal control over your business comes at a cost. You’ll also be personally responsible for company debts and other liabilities. For example, if your company declares bankruptcy, creditors will be able to go after personal assets like your home and savings account. That’s why many franchise owners eventually form another common type of company structure, the LLC.
What is a Franchise LLC?
A limited liability company (LLC) is a type of franchise business structure that helps limit owners’ liability to the value of the business. In other words, if an LLC is sued or declares bankruptcy, creditors and courts can’t go after the owners’ personal assets. This is what makes LLCs another popular choice for franchise owners.
How is an LLC Set Up?
The fundamental document of an LLC is called an operating agreement, which outlines how the franchise will operate and what the company owners are allowed to do. LLC owners are called members, and the operating agreement can give different members specific voting power, profit-sharing distribution, and other benefits. To start an LLC, you’ll need to register your franchise with the state and pay a filing fee. So, while LLCs offer a lot more protection than sole proprietorships, they’re also subject to more administrative costs and government accountability.
How are Franchise LLCs Taxed?
If you’re the sole owner of an LLC, then the company will usually be treated like a sole proprietorship—that is, all franchise profits and losses are filed in your personal tax return. An LLC with multiple members can be taxed as either an S-corporation or C-corporation, and you’re free to choose which is more advantageous for your tax situation (see below for more information on corporate taxes).
LLCs are simple to set up and are perfect for situations when you want to limit your liability and have a few owners you know well, like trusted business partners or family members. But if you’re looking to expand your franchise by getting a small business loan or bringing in more investors, then you should consider the business structure with the most flexible ownership options: the corporation.
What is a Franchise Corporation?
A corporation is a business entity that’s distinct from its owners. What makes corporations distinct from other structures like sole proprietorships and LLCs is that they’re legally treated as their own unit—corporations are taxed and held legally liable separately from their owners.
When most people think of a corporation, they think of large, publicly traded companies that make millions or billions in revenue per year. While these entities are certainly corporations, any kind of business can be set up as a corporation—from a Fortune 500 company down to a small, first-time franchise.
How is a Franchise Corporation Set Up?
Franchise corporations are set up through their articles of incorporation, a document that outlines the basic information about the corporation, such as:
- The name and location of the corporation
- The names and addresses of the corporation’s directors and officers
- The number of authorized shares
- The name and address of the corporation’s registered agent (the corporation’s first point of contact for legal purposes)
Corporations are very different from LLCs and sole proprietorships because there are many different types of stakeholders. Let’s go through each in detail.
A director is charged with making major policy and business decisions about the corporation. A corporation can have a single director, and multiple directors are known collectively as a board of directors. There’s no limit to how many people you can have on your franchise’s board of directors, though you do need to specify the number of directors in your articles of incorporation. Since the board of directors usually votes on decisions, it’s almost always a good idea to have an odd number of directors to avoid tie votes.
Corporate officers are people who are tasked with carrying out the decisions of the directors and managing the day-to-day operations of the company — your everyday workplace leaders. Many states require corporations to list at least three officers:
- President: in charge of overall responsibility for managing the corporation
- Treasurer: in charge of managing the corporation’s finances and bank accounts
- Secretary: in charge of maintaining the corporation’s records
Although you’re required to list these positions in your articles of incorporation, it’s usually OK if the same person holds all three offices.
Shareholders are the actual owners of the corporation. They can vote to add or remove board members of the corporation, making them the most powerful people in the corporation.
Shareholder ownership is measured in shares. A shareholder invests money into the corporation in exchange for shares, which gives them voting power as well as rights to collect a portion of the corporation’s profits.
Typically, an owner with more shares of the corporation has more voting power and is entitled to a greater portion of the company’s profits, but this isn’t always the case. For example, the corporation can issue different types of shares that give their owners different levels of voting power per share.
As you set up your franchise corporation, think carefully about who you want as a shareholder because they ultimately hold the most power in the company. Once someone is made a shareholder, it’s very difficult to remove them, even if you have the most voting power. That’s because all owners are entitled to be compensated for their stake in the company, and you won’t be able to remove an owner or sell your company without buying them out.
As with other types of franchise entities, employees are compensated by the corporation but have no other legal stake in the business beyond that. Keep in mind that employees can be anyone who contributes to the corporation by working — that includes officers and family members as well as you, the workplace leader. As an employee, you’ll have to pay income taxes like everyone else, but on the other hand, you’ll have access to other employee benefits such as health insurance.
How Are Franchise Corporations Taxed?
There are actually two major types of corporations, C-corporations and S-corporations, and each is taxed differently.
As a C-corporation owner, you’ll be taxed twice. The first tax is at the corporation level, which is based on the franchise’s revenue minus deductible expenses like payroll, rent, interest on business loans, and other operating expenses. Any money that’s left — the profits — go to you or are split between the corporation owners. Any profits you receive from the corporation are then treated as personal income, which means you’ll have to pay personal income taxes.
When you own a franchise S-corporation you only get taxed once. That’s because all corporation profits are automatically passed to the company owner(s) and treated as personal income. So, while you won’t have to worry about corporate taxes with S-corporations, you’ll always need to report the company profits or losses on your annual personal tax return.
S-corporations can be an excellent way to save money on taxes, but they come with a few restrictions. First, S-corporations are limited to 100 shareholders, and they must all be US citizens. Also, keep in mind that not every state recognizes S-corporations for tax purposes. If your franchise is set up in New Hampshire, Texas, Tennessee, or the District of Columbia, then you’ll need to file your state taxes as you would for a C-corporation — though you’ll still be able to avoid double taxation on your federal taxes.
Compared to sole proprietorships and LLCs, corporations are complicated to set up and expensive to maintain. If you want to expand or even sell your franchise, then a corporation offers an ownership structure that protects everyone involved.
What Type of Business Entity is Best for a Franchise?
In summary, the best type of business entity for your franchise depends on how you want to operate and finance your business. To recap:
- Choose a sole proprietorship if you’re just starting out and want to quickly set up your business. All you need to do is apply for an EIN and you’re ready to go.
- As your franchise is settled, you can always switch to an LLC so that you can limit your personal liability and bring in trusted partners to invest in and help manage your franchise.
- Finally, when you’re looking for an outside investor or want to explore an M&A, go for a corporation, which will allow you to divide ownership into clearly defined shares.
All Franchises Are Always About People
Whatever business structure you choose for your franchise, always remember that the key to succeeding is putting people first. At Confie, we always value culture and employees above everything. Get in touch with us today to learn more, or give us a call at (714) 252 2500.