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Is an LLC the Best for My Franchise Business?

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January 10, 2022
Author: NCH

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Some of today’s biggest franchises include McDonald’s, Subway, 7-Eleven, Hertz, and Marriott. In fact, there are more than 750,000 franchises in the United States, providing jobs to more than 8 million people.

While the restaurant industry comprises numerous international franchises, franchises exist in every type of industry. For example, convenience stores, such as 7-Eleven and Circle K; educational franchises, such as Kumon Math & Reading Centers; eye care centers, such as Pearle Vision; spas, such as Massage Envy; real estate professionals, such as RE/MAX; and specialty retailers, such as Ace Hardware.

This begs the question:

Why Are Franchises So Popular?

Franchises—defined as one business (the franchisee) paying another (the franchisor) to use the franchisor’s business model and trademarks—are extremely appealing because owning a franchise allows you to work for yourself—but not yourself.

Franchising enables you to open your own business with the guidance and support of a larger parent company. Not only are you the boss, but the franchisor provides a ready-made outline for your new business to follow. Using this outline can also greatly simplify and reduce the pain sometimes associated with starting and growing your business.

Buying a franchise can be a viable option if you want to become an entrepreneur but don’t want the risk of building a business. The risk is low, and the revenue possibility is high. Apart from high-profit margins, you are provided with the support and resources of a larger company.

However, franchises still come with some liabilities. Although affiliated with a larger, well-established organization, you still carry personal liability for your franchise.

And that’s where legal structures come into play. 

The Importance of Legal Structures

Choosing the best legal structure is a big deal for new franchisees because the legal structure of a franchise can dictate legal obligations, tax implications, operations, and profits. Simply put, determining the proper legal entity should be decided before signing a franchise agreement.

The most common legal structures include corporations, sole proprietorships, and limited liability companies (LLCs). Let’s take a closer look at LLCs and how they function within franchises:

What Is an LLC?

An LLC combines the benefits of a corporation and a partnership or sole proprietorship. It offers limited liability to its owners, meaning their personal assets are protected from the company’s debts and liabilities. This means that if the company faces legal action or debt, the personal assets of the LLC’s members (owners) cannot be used to satisfy those obligations. 

Why Create One?

As mentioned earlier, the main reason to form an LLC is to limit personal liability because LLCs have their own existence. Think of them as artificial people. The LLC owns the business, not the people forming it. LLCs enter into their own contracts and deals, can sue and be sued, and are liable for their own debts and obligations.

How Do You Start a Franchise LLC?

Step 1: Research and Choose a Franchise

Look for various franchise opportunities to find one that aligns with your interests, skills, and financial capabilities. Consider factors such as the franchise’s reputation, track record, initial investment requirements, ongoing fees, and support provided by the franchisor.

Step 2: Review the Franchise Disclosure Document (FDD) 

Obtain and carefully read the franchisor’s Franchise Disclosure Document (FDD), which provides detailed information about the franchise opportunity, including the company’s background, financial performance, fees, obligations, and legal agreements.

Step 3: Secure Financing 

If necessary, get financing to cover the initial investment and operational expenses. Options may include:

  • Personal savings.
  • Bank loans.
  • Small Business Administration (SBA) loans.
  • Other sources of financing tailored to franchise businesses.

Step 4: Obtain Necessary Licenses and Permits 

Secure any required licenses, permits, or certifications to legally operate your franchise business in compliance with local, state, and federal regulations. This may include business licenses, health permits, zoning approvals, and tax registrations.

Step 5: Secure a Location

If your franchise requires a physical location, such as a retail storefront or office space, find a suitable location that meets the franchisor’s criteria and local zoning regulations. Negotiate lease terms and get any necessary permits for renovations or build-outs.

Step 6: Form the LLC

Choose a suitable name for your franchise LLC that complies with state regulations and reflects your business identity. File articles of organization with the appropriate state agency and pay the required filing fees to establish your LLC officially.

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Advantages of an LLC for a Franchise Business

Limited Liability Protection

As with any business structure, the owners of an LLC are typically not personally liable for the debts and liabilities of the company. In the event of a lawsuit or financial trouble, the owner’s personal assets, such as their homes or savings accounts, are protected.

Flexibility in Management and Ownership 

LLCs offer flexibility in both management and ownership structures. Franchise businesses often involve multiple stakeholders, including the franchisor, franchisee(s), and potential investors. Moreover, an LLC allows for various ownership arrangements, such as multiple members or a single-member structure, as well as member-managed or manager-managed structures.

Pass-Through Taxation 

In other words, profits and losses of the business pass through to the owners’ individual tax returns, avoiding double taxation at both the corporate and individual levels. This can result in tax savings for franchise owners, especially if operating in a high-tax jurisdiction.

Operational Autonomy

While franchise businesses operate within the framework and guidelines set by the franchisor, forming an LLC allows franchisees a degree of operational autonomy. Within the boundaries of the franchise agreement, LLC owners have the freedom to make day-to-day business decisions without constant interference from the franchisor, giving them more control over their operations.

Potential Downsides of Forming an LLC for a Franchise

Franchise Agreement Restrictions

Many franchise agreements have specific requirements or restrictions regarding the structure of the business entity. Certain franchisors may prefer or even mandate a different business structure, such as a corporation, which could conflict with the desire to form an LLC.

State-Specific Regulations and Fees 

LLCs are subject to state-specific regulations and fees, which can vary widely. Some states have higher initial filing fees and ongoing LLC compliance requirements than other business structures. Franchisees must ensure they understand and can afford these costs.

Complexity in Multi-State Operations 

If the franchise operates in multiple states, the complexity of compliance and regulations increases. Each state has its laws governing LLCs, taxation, and reporting requirements. Managing these complexities can be time-consuming and may require professional assistance.

Potential for Double Taxation 

Although LLCs offer pass-through taxation, where profits and losses are reported on the owners’ personal tax returns, some states impose additional taxes or fees on LLCs. Also, if the LLC elects to be taxed as a corporation, it could be subject to double taxation.

FAQs About Franchise LLCs

Who owns the LLC?

Ownership of an LLC can vary based on its structure and the agreements among its members. In a franchise business, the LLC may be owned by one or more individuals (franchisees), a parent company, or a combination of both. The franchisor retains certain ownership rights and control over the franchise system as outlined in the franchise agreement.

In what way are the LLC’s losses and profits managed?

Managing an LLC’s losses and profits depends on its operating agreement. Generally, LLCs have flexibility in distributing profits and losses among their members. By default, LLCs are pass-through entities, meaning that profits and losses “pass through” the business to the members’ tax returns. 

How are LLCs taxed?

LLCs are taxed based on the adjusted gross income of the owners but are usually treated as pass-through entities; the profits and losses of the business are reported on the member’s tax returns. This avoids double taxation at both the corporate and individual levels.

However, LLCs can also be taxed as a corporation by filing Form 8832 with the IRS. Doing so might be beneficial depending on the financial situation and goals of the LLC.

Can a franchise be an LLC?

Yes, a franchise can be structured as an LLC. In fact, forming an LLC is a common choice for franchise businesses due to the limited liability protection it provides, as well as the flexibility in management and ownership structures. Operating a franchise as an LLC allows the franchisee to enjoy the benefits of both franchising and the LLC business structure. 

LLC vs. S-Corp vs. Sole Proprietorship: Which Is the Best for Your Franchise?

LLCs

  • As discussed earlier, LLCs are designed to protect owners’ personal assets from business debts and liabilities, providing security in case of lawsuits or financial issues in a franchise. 
  • LLCs are taxed as pass-through entities by default, meaning that profits and losses flow to the owners’ tax returns. This can result in tax savings and simplified tax reporting.

S-Corporations (S-Corps) 

  • S-Corp owners can receive a portion of business profits as distributions, which are taxed at the individual level, potentially resulting in lower overall taxes than self-employment taxes in a sole proprietorship. 
  • However, S-corps tend to have stricter eligibility requirements, such as limitations on the number and type of shareholders, and they require more formalities in terms of governance and record-keeping.

Sole Proprietorships

  • A sole proprietorship is the most straightforward business structure, with the owner being the sole operator of the business. 
  • While easy to establish and operate, sole proprietorships lack the formal legal separation between the business and its owner. This means the owner has unlimited personal liability for the business’s debts and obligations, posing a significant risk. 

The Bottomline

Determining whether an LLC is the best choice for your franchise business will vary depending on various factors, including your specific circumstances, goals, and preferences. However, for many franchise businesses, an LLC offers a compelling combination of limited liability protection, operational flexibility, and tax advantages.

Ultimately, the decision should be based on evaluating your business, risk tolerance, and regulatory considerations. You can determine whether an LLC aligns with your franchise business’s needs and aspirations by seeking expert guidance.

Our business formation experts at NCH can help you decide if an LLC is right for your business. Call 1-800-508-1729 to request further assistance!

DISCLAIMER: The above material has been prepared for informational purposes only, containing opinions of the provider and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. Please consider consulting tax, legal, and accounting advisors before engaging in any transaction.

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