Choice of Business Structure

PUBLISH INFORMATION

Minorities in Franchising
July 2003: Second Edition
Special Edition of Franchising World
International Franchise Association
 

The selection of a franchise business structure requires an analysis of many different factors, including but not limited to: liability exposure, state and federal tax implications, and administrative requirements and expenses. The following types of business structures are normally used by franchised businesses:

1. Sole Proprietorship;
2. General Partnership;
3. Limited Partnership;
4. Subchapter C-Corporation ("C-Corp");
5. Subchapter S-Corporation ("S-Corp); and
6. Limited Liability Company ("LLC").
    

General Description of Business Entities

Sole Proprietorship. A sole proprietorship, the simplest business format, consists of one person operating a business. No state filings or registrations are required for a sole proprietorship to operate a business. (Please note that any individual or entity that does business using a name other than his, her, or its legal name must file a local trade name or assumed name registration – normally with the county of business. This filing is in addition to the state filings discussed below.)

General Partnership. A general partnership consists of two or more individuals or entities who conduct business together. No written agreement or state registrations are required for a general partnership to operate. It is advisable, however, for partners to have a written partnership agreement to clearly set forth their agreements and intentions. Partnerships are very flexible business structures, since partners can agree to operate the business in nearly any manner that suits their personal desires. General partners do, however, have joint and several liability for each others' actions and for all debts of the partnership.

Limited Partnership. A limited partnership, which has the flexibility of a general partnership but is designed to protect the limited partners against liability to third parties, also consists of two or more individuals or entities that jointly own and/or operate a business. A limited partnership must have at least one general partner, one or more limited partners, a written agreement, and a certificate of limited partnership that is filed with its state. Although the limited partners have very limited liability, the general partner of a limited partnership has no limits on his or its liability for partnership debts or actions. Therefore, most limited partnerships have a corporation or LLC as the general partner.

Corporation. A corporation (whether "S" or "C") is a separate and distinct legal entity, created under state law. The shareholders or owners of a corporation have only limited liability for the actions of the corporation. An S-Corp, made such by its making a special tax election, has certain tax benefits, but has limitations on who can be shareholders. For example, an S-Corp can have a maximum of 75 shareholders, and it may not have non-resident aliens, certain trusts, or another corporation (unless the other corporation owns 100%) as a shareholder. All corporations must file their articles of incorporation and other information with the state of incorporation and must comply with certain formalities and recordkeeping. Any business that intends to go public in the near future would normally incorporate as a C-Corp.

Limited Liability Company. An LLC is basically a cross between a corporation and a partnership. An LLC is designed to have the liability limitations of a corporation but the flexibility and tax benefits of a partnership. An LLC can be owned by an unlimited number of members, is organized under state law, and must file its articles of organization and other information with its state of organization. An LLC allows flexibility of and by its members as compared to a corporation (for example, distributions to the members can be made on a basis other than ownership percentage), and if drafted correctly, should allow the members to have the "flow through" taxation of a partnership (as mentioned below.)
  

Liability Exposure

Because we operate in a litigious society, franchise companies must analyze their tolerance for personal liability when determining their business format. General partnerships and sole proprietorships do not offer any limitation on liability for acts by or obligations of the business. Any business organizer who intends to reduce his individual liability should consider a corporation, LLC, or a limited partnership with a corporate or LLC general partner. Although it may be tempting for many new businesses to open up as sole proprietorships or general partnerships, simply because it seems easier and cheaper, one unplanned lawsuit (by a customer or competitor, for example) that is not fully covered by insurance could wipe-out all personal as well as business assets or a new business owner.

Franchisors normally require the principal individuals of a franchisee business entity to execute personal guaranties for all material terms of the franchise agreement (although a principal might successfully negotiate certain limitations on such guaranty.) However, since the primary purpose of doing business as a protected entity is to limit personal liability to customers, third-parties, and the general public, most franchisees choose to do business as an entity with limited liability, despite having individual personal liability to their franchisors.
  

Tax Implications

Another important factor in the selection of a business structure is the tax consequences for each respective entity. While a C-Corp provides a shield from personal liability, its earnings will experience federal "double taxation" as they will be taxed at the corporate level and again when distributed to shareholders. There are, of course, some methods to minimize the double tax burden for C-Corp's. For example, paying reasonable salaries instead of paying dividends when shareholders are providing services to the corporation allows the corporation to deduct such salaries from its earnings.

Sole proprietorships and partnerships are not separately taxed for their earnings, so all earnings are taxable only at the individual owner level. S-Corp's and properly formed LLC's are also designed to allow the tax liability to "flow through" to the individual owner. So, there is no double taxation of these entities. Further, the individual owners of sole proprietorships, partnerships, LLC's and S-Corp's can use their proportionate share of business losses to offset their other income. This benefit should be considered if the franchise business is expected to incur losses in its first year or two of operation.

State taxes should also be considered when determining a business structure. Because certain states now tax the income of corporations and LLC's, many franchise companies have begun to do business as limited partnerships (with a corporation or LLC as the general partner owning 1% or so), in order to avoid the state income tax. (In Texas, this is referred to as a franchise tax.)
  

Administrative Burdens and Expenses

In addition to liability protection and tax reduction concerns, business organizers should consider the administrative burdens, restrictions, and expenses associated with each entity structure. For example, while a corporation, limited partnership, and LLC all provide a liability shield, each of these business structures creates different administrative burdens and expenses. These business entities must each prepare and file formation documents and income tax returns, but C-Corp's and S-Corp's also have on-going meeting and reporting obligations. So, many practitioners find an LLC to be less administratively burdensome than a corporation or a limited partnership with a corporate general partner. In addition, LLC's allow greater flexibility than corporations. For example, equity distributions can be made by LLC's in a manner agreed to by the owners, and not strictly on the basis of ownership. This can be useful when, for example, only a portion of the individual members or limited partners work in the business and others are mere investors for the long-term of the business.

If a business is started as a sole proprietorship or general partnership to keep administrative burdens and expenses to a minimum, this decision should be re-evaluated as the business and individual owners' assets grow. Eventually, some cost-effective liability protections and tax planning strategies should be put in place.
  

Summary

As set forth above, the right business structure depends on the unique concerns of each individual business organizer. There are advantages and disadvantages to each business structure. The issues mentioned above should assist the reader with some initial factors to consider before selecting a business structure.

     
STRASBURGER & PRICE, LLP  •  DISCLAIMER