One of the biggest misconceptions about owning a franchise business is that you will automatically receive personal asset protection. Just because the parent company is registered as a limited liability company (LLC) or corporation does not mean that each franchisee receives this same business structure!
The LLC is a popular option for all sorts of businesses looking for asset protection, and it has a handful of other major advantages as well. Of course, forming an LLC isn’t the only option for your franchise business, so our mission is to help you decide if it’s the best choice for you.
There are many different factors to consider when you’re forming a business entity for your franchise, so let’s dive into the details of the LLC to figure out if you should form one.
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What Is an LLC?
First off, let’s quickly outline what an LLC is. LLCs are formal legal entities that are typically taxed similarly to sole proprietorships and general partnerships, in that the owners include any company profits or losses into their personal returns — the LLC itself does not owe income taxes. An LLC may also elect to be taxed like a corporation, although this is not a very common option.
There are similarities to corporations too, especially when it comes to financial responsibilities. In an LLC, the owners or members are not usually personally accountable for the financial status of the business. This means that if someone sues your LLC, your personal assets are not at risk.
Why Starting an LLC for a Franchise Is Important
Personal Asset Protection
The top reason to form an LLC for a franchise business is to gain access to the personal asset protection provided by this business structure. Whether you operate a restaurant in a popular fast-food chain or a retail convenience store with a wide variety of products, you need the limited liability protections that an LLC can provide.
With a franchise, it’s important to form an LLC before you ever sign your franchise agreement. This is because it’s vital to have personal asset protection before you start transacting business. If you don’t, a creditor could claim that they did business with your company when it was a sole proprietorship or general partnership, and the courts would likely grant them access to your personal assets.
As an example, let’s say that a customer slips on a wet spot on your floor, falls over, and injures themselves. If you operate your franchise as a sole proprietorship or general partnership, your personal assets — like your house, car, personal bank accounts, etc. — would be at risk if that customer decides to sue your business.
On the other hand, if you form an LLC for your franchise before you begin conducting business, and you operate and maintain that LLC in a compliant fashion, the scope of your customer’s lawsuit will be limited to your business assets. In other words, your personal assets will be protected by the business structure you’ve chosen.
This is just the tip of the iceberg when it comes to the advantages of the LLC for a franchisee. Another important aspect is taxation. The LLC actually provides its owners with a selection of options regarding how they want the business to be taxed, which can save you a considerable amount of money compared to simply operating as an informal business entity.
Sole Proprietorship/General Partnership
Your franchise LLC can be taxed as a sole proprietorship (for single-member LLCs) or general partnership (for multi-member LLCs), which is the default option. With this tax structure, your franchise business itself does not pay taxes, but rather the profits are passed through the business entity and your owners pay taxes on that money when they file their own personal taxes.
You can also choose for your franchise to be taxed as a C corporation, although this option isn’t very popular because it subjects your business to what’s known as double taxation — meaning that your profits are taxed first on the corporate level and again on the personal level when they’re distributed to your owners.
The other option is S corporation taxation. There are quite a few limitations to electing S corp taxation, but most franchise businesses have no trouble meeting these requirements — your business cannot have more than 100 owners, they all must be either residents or citizens of the United States, etc.
S corp taxation can help your franchise save money by reducing your self-employment tax burden. Instead of paying self-employment taxes (a 15.3% tax that includes the employer and employee portions of Medicare and Social Security) on all of your business income, you can pay yourself and your co-owners a reasonable salary for your roles and only pay self-employment tax on that portion of your income, while you can reinvest the rest of it into your business without paying this tax.
Compared to operating a sole proprietorship or general partnership franchise business, the S corp taxation model can save you quite a bit of cash that you can use to make improvements to your business, rather than writing a big check to Uncle Sam.
Enhanced Credibility and Name Uniqueness
Finally, an LLC structure can enhance the credibility of your franchise business venture. Informal business entities don’t have exclusive assumed business names and typically operate under the personal name(s) of their owner(s). For instance, if your name is Johnny Smith and you operate a franchise sole proprietorship, your company’s name is also “Johnny Smith.”
Of course, this issue is much less important with franchises, because the public perception of a franchise is typically more in line with the parent company than the individual franchisee. Still, it’s undeniable that your vendors and business clients will take you more seriously if you form a formal business structure.
With an LLC, you not only have the rights to exclusive use of a business name, but you will also have either the phrase “limited liability company” or the letters “LLC” in that business name. This provides your business with a jolt of respectability because vendors, partners, and clients respect the professionalism displayed by an LLC. Also, they typically feel more comfortable writing checks to a business entity rather than to an individual.
How to Start a Franchise LLC
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The formation process for LLCs varies depending on which state you’re forming one in, but in general, the process has some universal steps that need to be taken no matter what state your business is located in. If you want a comprehensive overview of all the steps required to form an LLC, check out our complete guide on the topic. The basic steps in the LLC formation process in any state are as follows:
1) Choose an LLC name
Coming up with the perfect name for your new LLC is an important step. You’ll need to choose a name that represents your company and describes what you do, and you’ll also have to make sure it isn’t already in use by checking your state’s business database.
2) Designate a registered agent
Your LLC’s registered agent (which can be an individual or a professional service) is responsible for receiving important document deliveries from the state — like service of process, annual report reminders, etc. — and forwarding them to you. The registered agent ensures that the state always has a reliable point of contact for your business.
3) File your formation documents with the state
The form used to create an LLC is usually called the Articles of Organization, although the name can vary (some states call it the Certificate of Formation or something similar). You’ll need to provide the state with some basic information about your business and its owners. In exchange, the state will formally create your LLC.
4) Acquire an EIN
The Employer Identification Number (EIN) is a federal tax ID number that essentially functions as a Social Security number for a business. The EIN allows your business to hire employees, pay taxes, apply for bank loans, and more. You can easily obtain an EIN from the Internal Revenue Service free of charge.
5) Create an LLC operating agreement
Most states don’t require operating agreements but every LLC should have one regardless. This is an internal document that outlines several key operational aspects of your LLC. The value of the operating agreement is how it can help prevent ownership disputes down the line by clearly explaining how the LLC will be run.
6) Create a financial infrastructure
You will need a business bank account for your LLC, and you’ll probably want a business credit card for work-related expenses as well. It’s also a good idea to use accounting software like QuickBooks or even hire an accountant to handle your bookkeeping for you.
7) Handle taxes, licenses, and permits
Depending on your state, you may need a general business license to operate your LLC in compliance with state requirements. In most states, you will need to register your franchise with the state before conducting business. Don’t forget to check with your state to see if there are franchise or privilege taxes assessed on LLCs, and also see if your municipal and/or county government entities have any further licensing requirements.
8) Understand maintenance requirements (annual reports, franchise taxes, etc.)
Again, these requirements can vary by state, but most states require some sort of regular report to ensure that your LLC’s info is up-to-date in the state’s business database. Some states require reports each year, while others only require them biannually or not at all. No matter what your state requires, you’ll need to stay on top of it to keep your LLC in good standing.
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If you want to use a service to form your LLC, there are dozens of options. We invite you to check out our full list of the best available LLC formation services, but we’ll also share a couple of the most popular options below.
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For most people, LegalZoom is the first name that comes to mind for LLC services due to their massive advertising budget. LegalZoom’s pricing and features may not compete on an equal playing field with ZenBusiness, but its brand power is notable and it receives good customer reviews.
For a side by side comparison, check out our LegalZoom vs ZenBusiness review.
Additional Resources for Starting a Franchise
1) Score.org Franchising Resources
Score.org provides franchise business owners with a wealth of information, from webinars to guides, blogs, virtual classes, and more. If you’re looking for advice on franchise agreements, financial considerations, or any other aspect of franchise ownership, you’ll likely find it with Score.org.
2) Free Management Library
Free Management Library offers resources for entrepreneurs in a wide variety of business types, and they have a great library of tools for franchising as well. They have plenty of information about preparing to become a franchise owner, how to choose the right franchise, funding your franchise, and more.
3) American Association of Franchisees & Dealers
The mission of the AAFD is to “educate the public regarding fair franchise practices, quality franchise opportunities, and to expose the unethical practices that have too long existed in the franchising community.” The AAFD’s website has information on fairness initiatives, buying a franchise, and much more.
Franchising.com markets themselves as “your complete guide to buying a franchise opportunity,” and we’re not about to argue! Their site has a ton of info for franchise business owners, with sections on news and opportunities, and information about conferences and webinars.
Frequently Asked Questions
What liability risks do franchise owners face?
In many cases, franchises have even greater liability risks than standalone businesses. For instance, let’s say you operate a restaurant franchise. As a restaurant, this business is subject to lawsuits due to slip-and-fall accidents, food poisoning issues, and more.
However, the franchise restaurant must also abide by the guidelines set forth by its parent company — if you don’t, you could lose your franchise or even be sued by your own parent company! As you can see, it’s vital for every franchisee to form an LLC or corporation to protect your personal assets.
Why should I form an LLC instead of a corporation?
Everyone’s situation is different, and we are not here to provide legal advice. That said, the limited liability company has some concrete advantages over the corporation that makes it the preferred option for most small businesses.
Corporations tend to have more complex formation and maintenance requirements, and they don’t have the taxation advantages of an LLC. The corporation has some advantages of its own (for example, it’s easier to attract investors to a corporation) that make it worth a look but the LLC is a simpler and more flexible business structure.
Can I serve as my LLC’s registered agent?
You certainly can! Every state allows entrepreneurs to serve as their own registered agents. However, while the role of the registered agent can seem like that of an unnecessary middleman, there is more complexity to this position than some people realize.
For instance, you would need to be present and available at your business location during all standard business hours. In addition, if you serve as your LLC’s registered agent, you may need to make your home address a matter of public record. Not only does this have privacy concerns, but there’s also the matter of unwanted junk mail as well.
Why should I hire an LLC service when I can form my own LLC?
The DIY route is always an option for LLC formation. However, LLC services are so affordable that there’s really no good reason not to use one these days. In addition, some of these companies often throw in free bonus features that make them an even better bargain.
Should I form my LLC in my home state, or choose a state like Delaware or Wyoming?
Some people like to form their LLCs in states with favorable legal settings. For instance, Delaware is often seen as the most business-friendly state, as it has an entire court system that’s dedicated solely to business matters. As for Wyoming, this state has some of the most generous anonymity laws for LLC ownership.
However, for most people, your best option is to simply form your business in your home state. Forming in a different state can be a tremendous hassle, and it can add some unnecessary complexity to tax issues as well.
How much does it cost to form an LLC?
The costs of LLC formation can vary quite a bit depending on which state you’re forming one in. For in-depth information about LLC formation costs in your specific state, take a look at our comprehensive guide to state-by-state expenses.
Start an LLC For Your Business
We break down the LLC formation process in detail for different types of businesses. View all of our guides below.
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