Choosing a Legal Form for Your Franchise

Sole proprietorship, corporation, LLC...know the option that's best for you <I>before</I> you buy a franchise.

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By Jeff Elgin

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Q: I'm all set to buy my first franchise, but I'm not sure what type of company I should have. Should I incorporate or do something else? What are the pros and cons, and how can I determine what's best for me?

A: This is one of those wonderful questions that can best be answered with the phrase "it depends." There is simply no right or wrong answer to the form of entity you should use unless and until you consider a few factors that relate to your own personal situation.

There are three basic forms of business entity: sole proprietorship, partnership and corporation. The basic differences between these forms relate to how income is treated for tax purposes and which assets are exposed to your potential liability (based on the operation of the business).

If you use a properly formed and maintained corporation structure for your business, the income from your franchise will be taxed in your corporation rather than on your personal return, and you may create a liability barrier between your personal assets and any claims made against the business. A partnership or sole proprietorship form of entity does not typically provide either of these characteristics.

There is another form of entity that is coming into fairly common usage--a LLC or limited liability corporation. In this entity form, you report any income on your personal return, but you do create a liability barrier to potentially protect your personal assets from business-related claims.

One caveat you need to be aware of: Using a corporate structure in a small business typically doesn't protect your personal assets from business liability in relation to contracts you execute. This is because most contracts require you to personally guarantee performance as a condition of doing business.

This is especially true, in your example, with contracts like your franchise agreement, your lease for the site of your franchise business and probably the contracts you have with the major suppliers of your franchise. Though it probably goes without saying, this will also most certainly apply to any loan you use to get your business started.

For this reason, many new franchisees are more interested in the corporate form for its tax differences than for its potential liability protection. The advantage they see is the potential that corporate income will be subject to tax rates lower than personal income. There are also possible benefits related to increased options for retirement accounts and different treatment of certain income tax deductions.

The flip side of these potential benefits is the double taxation whammy you're exposed to if you have excess funds in the corporation that you want to get into your pocket. You've already paid income taxes on these dollars at the corporate level, but you're almost certainly going to have to pay personal taxes on the dollars as well to get them into your personal accounts. This isn't a pleasant prospect for most franchisees.

As you can see, there are a number of variables for you to consider before making the decision on what legal entity makes the most sense for you as a franchisee. There is no right or wrong answer, since it all comes down to your individual situation. Though you might get lucky and guess the right answer, you should definitely get professional advice from your accountant and/or attorney about which form would be most beneficial for you.

Jeff Elgin

Jeff Elgin has almost 20 years of experience franchising, both as a franchisee and a senior franchise company executive. He's currently the CEO of FranChoice Inc., a company that provides free consulting to consumers looking for a franchise that best meets their needs.

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