Choosing the Right Entity for Your Franchise
If you’ve reached this point in your franchise journey, you’re getting closer and closer to opening the doors of your business! But hang in with us a while longer: the topic of entity types is not very sexy, but it can have major legal and tax implications for you in the future. In this chapter, we will help you understand why your business entity matters and cover the pros and cons of each option.
Why Does the Entity Type of My Franchise Matter?
A business entity is an organization created by an individual (you) that performs the actions of running a business. An entity can own property, receive a loan, enter into a contract and keep the individual legally separate from the business – among many other things. They have many benefits, but it’s the last one that is most often regarded when selecting the appropriate entity: how to best protect the individual from legal action or financial failure that the business may experience.
For example, the appropriate entity protects the owner from personal liability (like being sued) and their personal property (bank accounts, houses) from being seized in the event of the financial breakdown of the business. The tax implications of business entities are also far-reaching, and are typically the other key element of selecting a business entity.
We’re about to jump into the different types of business entities, but first a quick reminder that you should consult an expert when making a big decision like this, et cetera, et cetera. We’ll cover the basics in this chapter, but it by no means covers the complexities and nuances of business entities. A.k.a., talk to a pro before selecting your entity.
The most common types of business entities are C corporations, limited liability companies (LLC), S corporations and sole proprietorships.
C Corporations
C Corporations, commonly referred to as C corps, are the most frequently used entity in the United States. With a C corp, you can grow your business through the sale of stock – and there is no limit to the number of stock holders. So, bonus.
Pros
- A c corp provides protection to directors, officers, shareholders and employees by limiting their liability.
- The corp will continue to exist, even if the owner leaves the company.
- As mentioned above, C corps are super popular in part because of the unlimited growth potential through stock sales.
- Also, as mentioned above, you’ll have no limit to the number of stock holders. If you can attract them, you can have them.
- A few tax advantages, including deducting certain business expenses.
- A c corp is the only entity type that can support financing through Rollovers for Business Start-ups, which we covered in chapter 7.
Cons
- C corps have double taxation, at the business’s revenue level and the stock holder dividend level. However, if the stock holder is also an employee and the salary they receive is considered “reasonable” by the IRS (a.k.a at market), it is treated as a business expense that the corp can deduct – thus reducing the burden of double taxation.
- Creating this entity comes with a number of filing and operating fees, making it more expensive to start than other options.
- The regulations surrounding C corps are also a little tighter than those of other entities. This is due to the limited liability that protects owners from certain obligations, like debts, lawsuits and financial failures…all of which equals more government oversight.
- And, courtesy of the point above, taxes must be filed on a quarterly basis for C corps.
- And last but not least, shareholders in a C corp cannot deduct corporate losses on personal tax returns.
S Corporation
An S corp is pretty similar to a C corp, mainly in the limited liability and perpetual existence sectors. But, of course, there are some major differences in the areas of tax implications and limited shareholder growth. So, don’t be surprised when the pros and cons lists below look pretty darn similar to what you’ve just read above.
Pros
- Limited liability, of the same flavor of a C corp: directors, officers, shareholders and employees are in the (limited) clear.
- This cool thing called “pass-through taxation” where shareholders can report profits and losses on personal tax returns.
- Single taxation. As in, income is not taxed on the business revenue side and the shareholder dividend side – only the dividends are taxed.
- Growth potential through the sale of stock – but stay tuned for the cons on this one.
- That whole perpetual existence deal, where the entity will continue to exist even if the owner peaces out.
- You get to file your taxes once a year like a standard W-2 wage earner.
Cons
- This entity is only available to U.S. citizens and permanent residents. (C corps and LLCs are more flexible.)
- Here’s that growth potential con from the pros list: an S corp can only have 100 stake holders, so your growth potential from sale of stock is limited. Also, all of your stake holders have to be people – not entities. Bummer.
- Like the C corp, there are some filing and administrative fees. Some states have also thrown in a franchise-specific tax fee here, just for fun.
- Complicated filing requirements can lead to mistakes, and those mistakes have been known to lead to the accidental termination of the S corp.
- This entity type doesn’t support the ROBS structure, which means the only way you can start debt-free is with a pile of cash.
Limited Liability Company (LLC)
An LLC is another super popular option because it is the most simple (and by that we mean the least complex, because let’s face it, all of this stuff is complicated). It comes with many of the perks of C and S corps, and you get to have a little string of letters following your company title, which is always a bonus.
Pros
- The protection of limited liability (obviously). This is a big one, as we’ve mentioned, because it protects you and your team from the debts and obligations of the business when things go wrong. Yay!
- That nifty pass-through taxation perk again – the profit and loss is reported on personal taxes, so no need for a corporate tax return.
- No citizenry requirements. Unlike the S corp, you do not need to be a U.S. citizen or permanent resident to start an LLC.
- That string of letters we talked about gives you a certain amount of business street cred – a.k.a. you’re looking super cool and official when dealing with vendors, partners and financial institutions.
- An LLC can be owned by a C-corp, which means people who already have a business but want to use ROBS to inject capital to fuel their growth are able to do so.
Cons
- One major downside to the super-cool LLC is that you cannot attract investors via sale of stock. Which, potentially, can stunt the growth of your company. Bummer.
- LLC revenue may be subjected to self-employment tax. The horror!
- You don’t know what you’re going to get from any given state, since LLCs can be treated differently depending on which state you’re in. Surprise!
- There is a chance of extra taxation if you convert your S, C or any other entity into an LLC.
Sole Proprietorship
The sole proprietorship is the simplest entity that can be used to operate a business. It itself is not a legal entity, which means losses and income are included on your personal tax return. The simplicity makes it a popular option, as well as the minimal setup fees.
Pros
- The simplicity, like we mentioned before.
- Minimal set-up fees in comparison to other entities
- Can mix personal and business property and funds (this is possible, but not necessarily recommended)
- No need to meet formal requirements (meetings, keeping minutes) of other entities
- Simple taxation structure
Cons
- There is no personal protection – you and your personal assets are on the line for all financial and legal failures or issues.
- No opportunity to grow through the sale of stock
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