What is the Best Legal Structure for your Franchise?
August 2, 2016
A critical decision: choosing the best legal structure for your franchise
Selecting the best legal structure is a major decision for new franchisees. Legal obligations and tax implications are only part of the challenge because the legal structure of a franchise can impact its operations and eventually, profits. Determining the proper legal entity is a key factor that needs to be designated well before signing a franchise agreement.
The most common legal structure options are S-corporations, C-corporations, sole proprietorships, general partnerships and limited liability companies. S-corps are becoming more popular in recent years among franchisees due to the tax benefits afforded to smaller businesses with fewer stakeholders.
However, there are pros and cons to each and so, information regarding the best legal structure for you is listed below.
The pros & cons of each legal structure
- Sole proprietorships and general partnerships
These entities are not the best legal structure for franchisees. According to Oblivious Investor, while they offer benefits for small businesses for their tax structure, they do not offer protection from individual liability. The reason for this is sole proprietorships and general partnerships are not separate from a franchisee’s personal legal identity. Thus, any liabilities and claims brought against the franchise would be strictly the obligation of the franchisee.
- Limited Liability Company
While LLCs are used by franchisees for the protection offered against personal liability from claims, their flexibility as independent legal entities and the few statutory requirements governing them, do not offer much for a franchise with equity investors. Delaget found that franchises under LLCs run into challenges when issuing equity to investors because they are not distributed in the same structure as corporations. If a franchisee has multiple investors into a franchise, LLCs become more complex from a tax perspective.
With that said, there are tax advantages because LLCs can be designated as flow-through entities, which means no corporate income tax returns need to be filed – all net income is taxed at the individual level.
C-corps are more ideal for the franchisor than the franchisee, primarily for their equity distribution for investors. This legal structure is most commonly used for publicly traded companies with several equity investors and executive boards. They are also troublesome for franchisees because C-corps are taxed at both the corporate and individual levels. The goal of any C-corp structure is to position a business for future growth by soliciting additional capital investment from investors. So if a franchisee anticipates rapid growth at some point, C-corps could be an ideal structure to reduce tax costs. But for those just starting, this is not an ideal structure.
The S-corp has gained in popularity among franchisees because of its tax structure. No federal income tax returns are filed because all profits and losses fall down to shareholders. These shareholders then report this information on their personal tax returns with a Form K-1. This is an ideal legal structure for franchisees because they will have a limited number of shareholders, and those shareholders assume the tax liability whether they receive any income from profits or not.
By now, you have realized that selecting the best legal structure for your franchise is a major decision, which requires consultation from an experienced business law attorney. Strictly speaking, however, the S-corp is an ideal option for smaller franchisees due to its flexibility and ability to generate profits without tax liabilities at the individual franchisee level.