Franchisee Structure: What Type of Business Entity is a Franchise? (featuring Elle Gerhards of Fox Rothschild)
Amanda: Let’s kind of move into all the different structures of the business. And we kicked the conversation off with, you know, the personal guarantee and what does that look like. You know, I’ve formed an LLC or a corporation, how am I still liable? So let’s just kind of break down different kinds of business structures that can be set up for a franchise, and then, the pros and cons of each one of them.
Eleanor: Sure. So nowadays…now, let me talk just briefly about how it typically works vis-a-vis the franchisor, and you. You may individually…some franchise systems will require you individually to sign the franchise agreement, and then, you can transfer the franchise agreement to an entity that you form solely for the purpose of operating the franchise. Some franchise systems will say, you know, “I want you to sign the franchise agreement.” If you have an entity form, you can sign in the name of the entity, and then, you know, you’re personally liable as a guarantor to that. So the one thing you wanna do is make sure that, if you are signing a franchise agreement in your individual capacity, that there’s an easy mechanism that allows you to transfer to an entity without having to, you know, pay any fee or do anything like that. In most cases, you know, that’s the case.
You know, I don’t really ever see sole proprietors anymore, that would mean you’re sort of operating in your individual capacity. There’s really no isolation of abilities, you’re not a separate entity. By far, I would say, the most popular entity choice for single-unit franchisees is the limited-liability company. So, you know, you may be out there and you understand…you may know, “Okay. Well, there’s corporations, and there’s S corporations, C corporations, and limited liability companies, and limited partnerships, and, you know, general partnerships. And for those of you who don’t know, a general partnership, or a sole proprietor, you know, you’re not gonna have that isolation of liabilities and operating as an entity.
An LLC is a very flexible great entity choice. Setting aside any tax issues or particularities you may have with your business, I’m talking very general, a limited-liability company is a great choice for most franchisees. And I say this because for a number of reasons. First is I, you know, it’s very flexible…first off is, every state now has a detailed limited-liability company law. So, you know, unlike 23 years ago, you know, there’s a body of law governing limited-liability companies in every state, every state regulator is very well-versed in them, they’re popular, everybody understands them now. You know, there’s no confusion there.
Second is the flexibility. So, you can own a limited…you know you can be a member of a limited-liability company and come up with any type of ownership structure or management structure that you want to and you just, you know, draft it into an operating agreement. So, you know, if your uncle wants to invest $100,000 in your franchise and he wants his money back first, you know, but you don’t wanna give him a voting right over the day-to-day operations but he wants to have a right to have a say in any of the financial decisions until his money’s paid back, and then, you’re also gonna take some distributions because you’re gonna manage it, you can structure that in any which way that you want to. It’s very, very flexible to come up with a mechanism to suit your needs.
The other thing with a limited-liability company is that, if you’re a sole member, then, for tax purposes, it’s really easy to have it treated as a disregarded entity. And you can just put the income on your individual-tax return and it makes, you know, your taxes each year, you know, a little bit, hopefully, less complicated and a little less expensive. But if you have a multi-member franchise, you know, multi-member LLC, then, you know, you could be taxed as…you can have the K-1s tax as a partnership and you’re not having that, you know, double taxation of a C-corp. You know, in most of the cases that I see, LLC is the most, you know, chosen entity structure for owning a franchise or even multiple units of a franchise.
Now, some franchise systems, or some franchisees will also look into forming S corporations. An S corporation is basically you’re forming a corporation and you’re choosing a selection status. In such a case, the limitations…now, in most cases, I would say, this is typically driven by your accountant or advisor or certain potential regulatory requirements on choosing an S-corp over an LLC. There are certain, and I’m not gonna get into the details on that, there are certain reasons to choose an S-corp over an LLC for tax purposes.
Now, the limitations on an S-corp is that S-corporations shareholders, the number of shareholders is limited, I think it’s 75. In most of our franchisees’ cases, that’s really not gonna be applicable so you may not care that much. What you would care about is the fact that there’s limitations on the type of shareholders. So, in most cases, you have to be an individual in order to be a shareholder in an S-corp. So if you have another person who wants to invest in your franchise but through an entity, then you’re gonna be limited there. If you have a franchise…you know, if you wanna come up with some sort of trust structure and have, you know, so put in a trust, that could be more complicated. There’s ways that you can do it to have ownership held in a trust, but, you know, you’re basically gonna be engaging some sort of attorney, or tax advisor, or accountant to sort of navigate those types of issues, which, with an LLC, it’s a lot easier in terms of just…you know, anybody who wants to be a member could be a member. It could be an entity, it could be a trust, you know, whatever.
The other thing is, as corporations, you can only have voting and non-voting stock. You can’t have various classes of stock. I don’t know if anybody…if you have ever looked at a complicated LLC operating agreement. You know, I’ve clients that have, you know, class A, B, C, D, E, and F of membership interests, and all of them have different rights. And so, when you’re dealing with issues where maybe someone is a passive investor and someone is an operator and you wanna have different types of distributions for each of those, like we talked about a few minutes ago, you really can’t do that with an S-corp the same way that you can do it with an LLC. But again, there are certain industries and certain circumstances where an S-corp makes a lot of sense. But again, you know, from a legal perspective, you know, we’ll often tell you, an LLC makes sense in this scenario. From a tax perspective or accounting perspective, you know, your CPA may have a different opinion, and then, those types of factors will sort of guide what types of entity choice you would choose in that case.
You know, unless you are planning on getting like venture-capital money or going public, you know, you really don’t need to worry about…you know, most…barring is something really unique to your situation, you’re probably not forming, you know, a C corporation in order to operate. And then, things like, you know, limited partnerships and limited-liability partnerships, you know, in most cases, an LLC is gonna be a better fit for you. You know, limited partnerships now, in most cases, in Pennsylvania for example, are, you know, smart moves for real-estate holdings, but otherwise, you don’t see them quite as much as you do with the LLC’s. And so, I guess those were kind of the, you know, entity planning.
When you decide to form an entity, you know, a question I get from franchisees is, “Well, why would I even bother if I have a personal guarantee to the franchisor?” Well, you have a personal guarantee to the franchisor, you do not have a personal guarantee to every single customer, every single vendor, every single supplier that you do business with. So, you know, you really want an entity for that isolation of your liabilities, so that if someone comes into your location and slips and falls and sues you, they’re suing the entity and they can’t get at your personal assets. If you have a dispute with a vendor supplier and they sue you, again, you know, they’re gonna be suing the entity, you know, maybe El Gerhards LLC, not El Gerhards the person. They’re not going after my house and my personal…money in my checking account. So that’s why it’s really important to have an entity formed.
One thing you have to remember is a lot of people say, “Well, I’ll use LegalZoom or I’ll use one of those websites to form an entity,” and, you know, I don’t wanna be self savvy enough to say never to do that, but I will just tell you that the limitations there are that they may put together stock forms to send to you, you know, they’re not gonna be giving you the advice on what entity to form, they’re not gonna be drafting operating agreements that are gonna suit your needs. And most importantly, you know, an attorney can give you advice on how to make sure that you’re not piercing the corporate veil and you’re operating as an entity and not just…I would say, you know, you have the entity, you know, on paper, but you’re not actually acting as a separate owner…or as a separate entity, as an owner, or a officer. It’s very important because, you know, there’s not a lot of assets in the business, and even if there is and someone sues you, they may try to go after you personally. And you wanna be able to say, “Oh, no-no-no. This is completely separate, you can’t go after my personal assets.” And you have to follow good corporate procedures to show that, and that means making sure you’re not commingling assets, making sure that you have insurance for the business, making sure that, you know, you’re signing checks and entering the contracts in, you know, your name as President, not as in your name individually. That if you’re leasing equipment, it’s in the name of the company. So, all of those types of things, you know, are gonna help you, you know, in maintaining that limited liability that you would have from forming an entity. The last thing you wanna do is go through the process of forming an entity only to find out…you know, only to not follow like very, you know, simple guidelines on the basic stuff. So…
Amanda: Yeah, and it sounds like…I mean the biggest purpose of these entities is the protection that they provide you. So, again, spend the money upfront to get somebody who’s got your best interests at heart so that you don’t, you know, cheap out on the front end and end up with a mess on your hands on the back end. And as we talk about this podcast as a way to educate people, that’s my biggest takeaway, is, you know, it may not be the easiest thing to do up front, especially when you’re talking about a franchise and all the costs that are associated with it, but better to protect yourself and rather to be safe than sorry when it comes to a lot of those things. Because, I mean, it sounds like it’s as unique as your fingerprint, right? All of the different…especially when you talk about the tax side of things, what’s that look like, and if you’ve got multiple investors and everything else that could potentially go on. And, you know, it may seem pretty basic and straightforward to you, but that may not be the case down the road, and you wanna make sure that you’re covered.
Amanda: Well, that’s, I believe, all that we have. Anything that we didn’t cover? Any, you know, advice that you would give to any…[inaudible 00:14:19] can’t use advice, but, you know, anything else that you wanna talk about or… Not advice, generally speaking.
Eleanor: You know, just generally. Listen, you know, like I said, I’ve been working with franchisees and franchisors for 12 going on 13 years now and, you know, it’s a great way for a person to be able to own a business. I think franchising, when done right, is just such an incredible tool for, you know, entrepreneur-spirited people to be able to own their own business but, you know, get that support and that leg up. So, you know, the last thing I would want anybody to take away from this is the idea that, you know, this is too complicated or this is too hard or this seems really restrictive. Franchising generally is a great opportunity for many, many people who, you know, find a lot of success with it. So I would say, you know, go into it with open eyes, and do your due diligence, and find your right, you know, partners, but trust that this has been a type of business structure that’s been around for a long time and it works for a lot of people.
Amanda: Absolutely. Well, thanks so much for being here. If our listeners wanted to reach out to you to get more information or, you know, somebody who’s potentially looking at purchasing your franchises, how can they get a hold of you?
Eleanor: Sure, great. Thanks. Again, I’m Eleanor Gerhards, I am the Co-Chair of the Franchising and Licensing Distribution Practice at Fox Rothschild. My phone number 215 918-3642 and my email address is firstname.lastname@example.org. Or you can google me, I’m sure in the website I’ll come up and you’ll be able to find me. But thank you so much for having me, it’s been a pleasure.
Amanda: Thanks for taking the time to be here, lots of great information. And I look forward to talking more soon.
Eleanor: Great, thank you.