Choosing a corporate entity for your new franchise
Americans love to eat out (and over the last year, are increasingly ordering in). The centrality of food to our culture likely explains why so many people dream of owning their own restaurant someday. Getting to be your own boss while serving delicious food and providing jobs to your community are just a few benefits of becoming a franchise owner.
Once you’ve committed to this exciting prospect, it’s the beginning of an exciting new journey. But what’s next? Now that you’ve made the decision, there are other big choices to consider.
The first step on this new career path is deciding on your corporate entity structure. The structure you choose will determine what you’re required to pay in taxes, what kind of personal liability you could face, how much paperwork you’ll need to do, and more. First, let’s break down the common structures for franchisees and the key differences between them.
Corporate entity structures – What’s on the menu?
The following four business structures are commonly-used structures for franchisees:
- Limited Liability Company (“LLC”)
- Limited Partnership
- C-Corporation (“C-Corp”)
- S-Corporation (“S-Corp”)
Each of these structures may appeal to a particular franchise owner or group of owners, depending on its unique needs: All four offer a certain level of liability protection.
Each is taxed very differently. Taxation can also vary from state to state, which is why you should always consult with a tax lawyer or accountant who is familiar with the laws in your state before making your final decision.
Let’s go deeper on each type of corporate entity structure.
Limited Liability Company (LLC)
A significant number of new franchise companies form as an LLC. The reason for this model’s popularity is that it’s relatively simple to form and offers a lot of flexibility. Additionally, LLCs allow for multiple owners (called members) and even different classes of owners. One of an LLC’s most appealing features is “flow through” taxation – i.e., no “double taxation,” as is the case with C-Corps. Generally, this type of structure requires less administrative set-up compared to a corporation.
Within a single-member company, the LLC’s owner reports the company’s profits (income or loss) on their individual tax return. This classifies the LLC as a “disregarded entity,” and negates the owner’s need to file a separate tax return for the company. If there are multiple owners, the LLC would file a partnership tax return and each member would receive a Form K-1 reporting their distributive share of the LLC’s income or loss, which is then reported on the member’s individual income tax return. There generally aren’t many cons to forming an LLC, but some jurisdictions levy a “franchise tax” on LLCs.
Like an LLC, limited partnerships are generally inexpensive and easy to form. Limited partnerships comprise at least one general partner who may finance or manage a for-profit business, as well as one or more limited partners who provide only capital to that partnership entity.
Typically, in limited partnership, the partners share profits and losses based upon the value or percentage of each partner’s capital contributions to their business. However, flexibility exists that allows partners to enter into agreements to distribute business profits and losses in the manner that best suits their respective business models. Like an LLC, a partnership is considered a “flow through” entity, making it appealing to franchise owners.
There are some unique advantages of the “C-Corp” structure, most relating to the limitation on liability and greater opportunity to extend and expand the number of shareholders. However, C-Corps face certain drawbacks, such as “double taxation” whereby profits are taxed when they’re earned and again when they’re distributed as shareholders’ dividends. Not only that, but C-Corp income or loss is captured at the corporate entity level, and shareholders can’t deduct corporate losses on their personal income tax returns. To avoid these concerns, many franchise owners choose to form a flow-through entity (like an LLC or a limited partnership) instead.
An alternative to a C-Corporation, “S-Corps” typically don’t pay federal income tax. Instead, the company’s profits and losses flow through to shareholders, who use a Form K-1 to then report income or losses on their personal tax returns. This “single taxation” is a prime advantage of choosing the S-Corp structure.
The downsides to the S-Corp structure include shareholder limitations. S-Corps are restricted to 100 shareholders, and they must be U.S. citizens or resident aliens. Shareholders are also taxed for any company income, regardless of whether they received any portion of that income. Additionally, S-Corps allow for only one class of stock. Every S-Corp requires its own tax return, no matter how many owners there are.
Which corporate entity structure is most appetizing?
Pros and cons exist for each of the four main structures. Many franchises opt for a pass-through entity, largely for the flow-through, “single taxation” advantage they offer. As mentioned earlier, a significant number of businesses opt for LLCs. It can help to talk to other restaurant owners, explore resources from the Small Business Administration, and continue your own personal research into the topic.
Each business has its own needs and particularities, so it’s critical to understand the challenges and benefits of all four corporate entity structures to ensure that you make the right decision for your franchise. Choosing the right structure for you and your business will set you up for success now and in the future. And of course, be sure to talk to a qualified tax lawyer or accountant before making your final decision.