How to choose the right legal structure for your franchise

by The Insights

By Nellie Akalp

The franchise model of doing business streamlines the entrepreneurial process. By operating as a franchisee, you can become a business owner without having to do the preliminary work required to build a business’s infrastructure and systems from scratch.

But even if a franchised location is associated with a larger brand, its owners are responsible for creating a business entity and managing all operations and administration at their site.

In this article, I will discuss some of the nuances of starting and operating a franchise entity.

Franchisee vs franchisor: what’s the difference?

First, let’s clarify some of the terminology I’ll be referring to throughout this article:

  • What is a franchisor? A franchisor is a business that sells others the right to open stores or sell products or services using its brand, expertise and intellectual property.
  • What is a franchisee? A franchisee is a person or business entity licensed to operate their private business (a franchise) under an agreement with a franchisor.

For example, McDonald’s is a franchisor; the owner of the McDonald’s restaurant in your town is a franchise.

Franchising and creating a business entity

Creating a legal business entity provides liability protection for business owners and may provide certain tax benefits. The underlying purpose of creating a franchisor’s entity is slightly different from why it is important to create an entity for a franchise location.

Franchisor entity

A franchisor forms an entity to sell franchisees the rights to open and operate a franchise using the franchisor’s trademark, intellectual property, and expertise. An independent legal and accounting entity, the franchisor entity protects its owners and the main business from the debts and legal obligations of franchisees.

Consider this hypothetical example: Subway is a franchisor. Suppose someone wants to sue the business after slipping and falling on a wet floor at a franchisee. The individual would sue the local franchised business, and the main franchised entity would be protected.

Often franchisors choose the limited liability company structure for their entity. Technically, a franchisor entity can be formed in any state. However, it is wise for franchisors to discuss their options with a lawyer and tax professional before making a decision.

franchise entity

A franchised entity is an entity created by a franchisee when purchasing the rights to operate a local franchise. Many franchisors will require the franchisee to create their entity before drafting contracts or a Franchise Disclosure Document (FDD), so that the documents can be put in the name of the entity. The franchised entities are generally LLCs. Many franchisors will not allow a company to buy a franchise because issuing shares would have significant legal and tax implications.

A franchisee must almost always register their entity in the state where they have physical presence, regardless of where the owner’s residence is. The physical location of the franchise will require permits, licenses, leases, etc., and therefore the business must be registered in that jurisdiction to obtain them.

Naming a franchise entity

Many franchisors create an entity under a name that implies its purpose of selling franchises, for example, Your Company Franchising Inc. or Your Company Franchise Sales, Inc. This makes it easier to differentiate between entities.

As for franchisees, they can use the franchise brand for marketing purposes by establishing a DBA (a fictitious name). However, their legal entity name must not include the name of the purchased franchise (because the franchisor has trademark rights to that entity name).

For example, franchisees would avoid registering their legal entities as Smith Subway, LLC or Smith’s Burger King, but instead could create DBAs like “Subway Store #1234” or “Burger King Woodland Hills.” Franchisors usually have a specific way in which franchisees should format their DBAs.

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What about multi-unit franchises?

A multi-unit franchise is when a franchisee purchases multiple locations. Typically, the franchisor will want each unit established as a separate legal entity with separate DBAs and licenses.

In some cases, franchisees may create a parent company that owns all of their entities underneath to keep things simple. However, this only works if the franchises are all owned by the same people.

Entity Requirements for Franchise Businesses

In addition to contractual obligations to franchisors, franchisees must comply with federal, state, and local requirements when establishing their business entity:

  • File formation documents with the state to establish the LLC or corporation.
  • Obtain an EIN (Employer Identification Number).
  • File a DBA (doing business as) to establish a fictitious name for the franchise location.
  • Create an LLC Operating Agreement (or Articles of Incorporation).
  • Register for payroll tax and other employment-related taxes.
  • Full registration of sales tax (generally does not apply to service-based franchises).
  • Filing of all business licenses and permissions required to legally operate on their site.

Become a franchisee

Are you curious about what it takes to start and run a franchise? Here are resources to help you assess feasibility and explore possibilities:

Starting a franchise business allows you to enter the world of entrepreneurship with built-in brand awareness and established systems and processes. This does not mean that it is completely “plug and play”! Make sure you get the legal and accounting advice you need to make sure it’s right for you.

About the Author

Nellie Akalp is a passionate entrepreneur, business expert, professional speaker, author and mother of four. She is the founder and CEO of CorpNet.coma trusted resource and service provider for business incorporation, LLC filings, and corporate compliance services in all 50 states.

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