The following is an excerpt from Section 3 – PRE-OPENING PROCEDURES.
Before you begin operating the Franchised Business, you will probably want to form an entity to serve as the operator. An entity is a legal fiction which allows a business to take on a separate existence apart from its owners, even though the owners still control the business.
There are many different types of entities recognized by the laws of most states (and by the IRS). However, for most franchisees who choose to form an entity, the best choice will usually be between:
- a C-corporation; or
- an S-corporation; or
- a limited liability company (LLC).
While this section provides some general information about the selection and formation of a business entity, there is no substitute for the advice of an experienced business lawyer and CPA. We suggest that you consult with your own professional advisors for more detailed information on this topic.
Overview of Entity Choices
Sole Proprietorship: If you choose not to form an entity to operate the Franchise Business, then you will be considered a sole proprietorship (if the franchise is owned by a single individual). A sole proprietorship exists when a single individual operates a business and owns all of the assets. A sole proprietor is personally liable for all debts and obligations of the business. Under a sole proprietorship, the life of the business is limited to the life of the individual proprietor. The sole proprietorship makes no legal distinction between personal and business debts, and it does not require a separate income tax return.
General Partnership: A general partnership exists when two or more individuals or businesses join to operate a business. A general partnership is a separate business entity, but creditors can still look to the partners’ personal assets for satisfaction of debts. If the franchise is owned by 2 or more individuals, then the individuals will usually be considered to be partners in a general partnership. General partners share equally in income and liabilities. A general partnership must file an annual partnership income tax return (separate from the partners’ personal returns).
Limited Partnership: A limited partnership is similar to a general partnership, but 1 or more of the partners will be general partners, and 1 or more of the partners will be limited partners. Creditors can still look to the general partners’ personal assets for satisfaction of debts, while the limited partners are usually shielded from this kind of liability. A limited partnership must be registered with the appropriate governmental office (typically the secretary of state’s office or the state department of corporations). A limited partnership must file an annual partnership income tax return (separate from the partners’ personal returns).
Corporation: A corporation is created when two or more individuals, partnerships, or other entities join together to form a separate entity for the purpose of operating a business. A corporation has a separate legal identity from its owners. The corporation offers protection to the business owners’ personal assets from debts and liabilities relating to the operation of the corporation. A corporation must be registered with the appropriate governmental office (typically the secretary of state’s office or the state department of corporations). Taxation of the corporation depends on the type of corporation formed.
Limited Liability Company: An LLC is an unincorporated business entity which shares some of the aspects of corporations and partnerships, but which has more flexibility. The LLC is designed to provide its owners with limited liability and pass-through tax advantages without the restrictions imposed on corporations and limited partnerships. An LLC must be registered with the appropriate governmental office (typically the secretary of state’s office or the state department of corporations).
The most important reason you might want to operate the Franchised Business through an entity (instead of as a sole proprietor) is to shield yourself from personal liability for the debts or other obligations of the Franchised Business. A C-corporation, an S-corporation or an LLC all offer this type of protection. A general partnership or a limited partnership does not offer this type of protection for all owners.
If you operate the Franchised Business as a sole proprietor, for example, you would be personally liable for all of the debts and other obligations of the Franchised Business. This means that you would be personally liable for unpaid debts (such as rent, wages and taxes), contract claims (such as under supply contracts and service contracts), and tort damages (such as if a customer was injured as a result of your business activities). Most business owners seek to avoid these types of personal liabilities by the use of a legal entity to own and operate the business.
Contrast this example with the situation where the Franchised Business is operated as an entity, such as a corporation or a limited liability company. In this situation, the entity (and not its owners) would be liable for unpaid debts, contract claims, and tort damages. Any lawsuit or other legal action to recover on this liability would be filed against the entity and not its owners. Only the assets of the entity would be at risk for the satisfaction of this liability. (Of course, if there are independent legal grounds for imposing liability on the owners, then an entity cannot shield the owners from the consequences of their own wrongdoing.)
The method of taxation of an entity can have a significant impact on your decision. For example, C-corporations are generally taxed differently than S-corporations, LLCs and partnerships (but an LLC may be able to choose to be taxed as a C-corporation if it wants to).
A C-corporation is taxed on its income at the corporate level at special corporate rates. If the C-corporation makes distributions to its owners, then these distributions would normally be treated as dividends and would be taxed (again) at the owners level. This results in “double taxation” of the same funds. For this reason, C-corporations are usually not the most tax-efficient choice. However, C-corporations do have other tax benefits – namely C-corporations can provide certain types of employee benefits (such as medical benefits, retirement plans, and tuition payments) on a tax-free basis.
S-Corporations are taxed differently. They are not taxed at the corporate level. Instead, they are considered to be a “pass-through entity.” This means that the income (or losses) of the S-corporation are “passed through” the corporation to the owners, who are then taxed at the owner level. So, the use of an S-corporation avoids the double-tax problem. Additionally, S-Corporations are easier to administer. But, they do not qualify for the tax-free employee benefits that C-corporations do. Another benefit of S-corporations is that their dividends paid to their owners are exempt from social security taxation (assuming that the S-corporation owners are paid a reasonable salary).
General partnerships and limited partnerships are also pass-through entities. They do not pay taxes at the partnership level. Instead the income and losses of the business are passed through to the partners.
LLCs can generally choose to be taxed as a corporation (meaning a C-corporation) or a partnership (meaning as a pass-through entity). Most LLCs choose to be taxed as a partnership in order to avoid the double-taxation problem.
Corporations are relatively expensive to administer. Additionally, there are fairly rigid rules for maintaining corporate formalities, such as requirements for periodic board meetings, shareholder meetings, corporate minutes, records of shareholders, etc. If the corporate formalities are not maintained, then there is a risk that the corporate entity would be disregarded and the owners could be held personally liable for the corporation’s debts or other obligations. The rules for LLCs, on the other hand, are much more relaxed. LLCs are much easier to administer than corporations.
Other Factors in Entity Choice
There are many factors that can affect your choice of entity. Of course, not all factors are of the same level of importance, and not all factors are important to all people. Here is a list of other factors that may be significant in your decision on forming an entity:
- the number and relationship of co-owners;
- the size and complexity of the entity; and
- any regulatory requirements relating to the particular business activity.
In most states, LLCs are cheap, they provide the best asset protection, and they have the flexibility to be taxed as a partnership or a corporation. But, you should check with your lawyer and CPA to find out what is best for your particular situation.
Where to Form Your Entity
The laws relating to the organization and administration of entities vary from state to state. Some states, like Delaware and Nevada, have a reputation for being business-friendly, because of state laws that protect the privacy of entity ownership information, low (or no) state taxes, etc. But, unless your business will be located in Delaware or Nevada, there will be little reason for you to form an entity in either of those states. Usually, the best choice is to form the entity in your own state.
Naming Your Entity
If you choose to form an entity and you have determined which type of entity to form, you will need to select a name for your entity. There are restrictions about what name you can use.
- Do not use the name that is the same as or similar to the name of another entity that is already registered in your state. This is prohibited under state law.
- Do not use the words “corporation” or “incorporated” (or any abbreviations of these words) unless your entity is a corporation. This is prohibited under state law.
- Do not use any of our Marks in the name of your entity. This is prohibited under the Franchise Agreement.
- Do choose a professional-sounding name. Your entity name will appear in your contracts and in other places where your customers and suppliers will see it.
- Do not choose a name that is long or confusing.
- Do not use profanity or off-color puns in your entity name.
Assumed Name Certificate
Regardless of whether you will operate the Franchised Business as a sole proprietorship, corporation, partnership or LLC, you must file an assumed name certificate with the appropriate governmental office. The assumed name certificate is sometimes called a trade name certificate or a fictitious business name certificate or a d/b/a registration. The appropriate governmental office is usually the county clerk, but you may be required to file at the state level and/or the city level. The purpose of this filing is so that the general public will be informed of the registered agent for a business and where official contact with the business can be made.
Each jurisdiction uses a different form. Generally, the required information includes, the name of the business, the street address of the business, the name of the business owner(s), the type of business to be conducted, and the expected period of operation. The expected period of operation should correspond to the initial term of the Franchise Agreement. Usually, each owner must sign the certificate and all signatures must be notarized. Fees generally range from $10 to $100. In some jurisdictions, you will need to place a fictitious name notice in a local newspaper for a certain amount of time.