What is the best entity type for my Franchise? (10 Minute Read)
Allen replied “That’s a great question Josh, but I am afraid I can’t give you an answer until I get some answers from you”. “Allen you’re the expert, just tell me what to do and I’ll take your advice” Josh replied. “Josh, I appreciate your confidence and wish it were that easy. Every franchise owner has to consider their specific financial situation when forming the entity to own and operate their franchise operation” stated Allen.
Josh took a deep breath and began to settle down a bit. While he was really excited about owning his franchise operation, he had not anticipated how involved the process was. Having worked in large corporation over the past 12 years, Josh should have known that things don’t happen as fast as we want them to, but after sorting through over 20 franchise concepts with his advisor before settling on the right one, attending the discovery day at the franchisor’s offices and signing the franchise agreement, he was starting to see that it he had a lot to learn and very little control of the timing.
Although Josh had always used a fraternity brother that was a CPA to prepare his taxes, he had met with Allen about a month ago upon the recommendation of his franchise advisor. Initially he planned to have the meeting and tell his advisor that he would look at using Allen’s firm sometime down the road. During that first meeting, Josh concluded that owning a franchise operation adds complexity to his financial and tax situation and while his fraternity brother knew individual taxes, he will need the expertise and experience in franchising that Allen’s firm brings to the table.
Allen explained to Josh that he should consider forming a corporation or limited liability company (LLC) to own and operate the franchise operation. According to Allen, both offer liability protection for the owners, but LLCs are generally favored over corporations for a few reasons. First, LLCs are easier to form and maintain and secondly, LLCs have more flexibility when it comes to taxation. Josh liked the idea of the LLC and said “Okay, just let me know what I need to do to get this LLC started.” Allen replied, “Hold on Josh, we’ve got more decisions to make before setting it up.”
“Will your wife be an owner in the LLC? You know that Michelle and you both are affected by this decision.” stated Allen. “We haven’t really discussed it and so far, it’s been my thing” replied Josh. Allen went on to explain that there are three basic types of LLCs: Single Member LLCs, Multi Member LLCs and LLCs taxed as Subchapter S Corporations. Although Single Member LLCs and Multi Member LLCs can both elect to be taxed as Subchapter S Corporations, the default tax statuses determine how the owner(s) are taxed unless the S Corp election is made. Even though Michelle might not be involved in the operations, Josh’s decisions on the LLC will definitely affect their joint tax returns.
Allen also explained that his firm generally recommends that real estate be held in an LLC separate from the franchise operating company. This helps in limiting owner liability risks and is better from a taxation standpoint.
“A Single Member LLC (SMLLC) is just like it says – An LLC with one owner. By default, SMLLCs are taxed on the owner’s individual tax return and reported on Schedule C therein.” explained Allen. “That sounds simple, so why wouldn’t we just form a Single Member LLC?” asked Josh. Allen went on to explain that if a franchise has few if any employees and the owner works in the operation, the SMLLC can be a good solution, but before settling on this option, franchisees should consider the anticipated number of employees, if the franchise will have debt, expected taxable income as the operation matures and if additional owners (members) may be admitted in the future.
Allen told Josh that while SMLLC members can generally deduct losses, taxable income from the SMLLC is generally subject to self-employment taxes (FICA and Medicare) possibly subjecting the franchisee to higher federal taxes than other options.
Josh, thought about those questions. He is planning to have 15 to 20 employees including a manager that will run the day-to-day operations. The franchise will be debt financed with an SBA loan along with the savings that he is putting in. His projections and experience of other franchisees indicate that the business will have losses in the initial 18 months due to the depreciation on the equipment and ramp-up period, but it should be generating a profit after that time.
Josh and Allen discussed how self-employment taxes work before Josh asked Allen “So what are some of the other options?”
Allen asked Josh “Remember when I asked you about Michelle being an owner in the business?” Josh replied “There you go again, answering my question with another question. Sure I remember that in the beginning of our conversation.”
Allen stated, “Josh, when there are two or more owners of the LLC, the LLC is automatically treated as a partnership for tax purposes. As a partnership, the LLC passes through taxable income/(loss) to its members on a K-1 that is reported in their individual tax returns. One of the biggest advantages is that members are able to utilize the debt of the LLC as tax basis. This allows members to deduct losses in excess of the capital contributed to the LLC. This is particularly beneficial when franchisees with existing profitable units start additional units that are debt capitalized.”
Allen went on to explain that partnership taxation also allows for the members to allocate profits and losses disproportionate to ownership. This can be advantageous when partners have differing individual tax situations. He also explained that when treated as a partnership, the members should not be issued pay checks. Members are compensated for their efforts working in the LLC via “guaranteed payments”. Such payments need not be based on ownership, but rather based on the work performed by the member. Taxes are not withheld from guaranteed payments, so members need to factor this income into their individual tax planning.
That situation seemed more complex, but it also seemed to fit Josh’s circumstances. He planned to open 5 locations over the next few years and although the operations would be profitable after 18 months, the depreciation and the debt basis seemed like advantages for his situation. Allen explained that Michelle could be added as a small partner in the LLC to qualify it as a partnership.
Josh asked Allen “Didn’t you say there is a third option for franchisees utilizing an LLC entity?” Allen replied “Hey you’re a good listener. Both Single Member and Multi-Member LLCs are able to elect to be taxed as a Subchapter S Corporation.” Josh quickly replied “I thought that LLCs were better than corporations. Why would an LLC want to make this election?”
Allen explained that when treated as an S Corporation, LLCs file a corporate tax return Form 1120S and report the taxable income/(loss) to members via K-1 forms similar to partnerships. The LLC is still an LLC, it’s just taxed as an S Corporation. Being taxed as an S Corporation allows members to be compensated with W-2 income and to earn income from their role as an investor/member in the business. The advantage here is that any income passed through to the member for their investment in the business is not subject to FICA and Medicare taxes while the owner is subject to FICA and Medicare taxes on the W-2 earnings. Keep in mind that S Corp LLCs must pay officers/owners reasonable compensation for the role that they perform in the company. Setting the compensation of officer/owners is of particular interest for S Corp LLCs since members are not subject to FICA and Medicare taxes on the earnings of the LLC. S Corp LLCs setting member compensation artificially low are susceptible to higher risk for tax inquiries and audit.
They discussed other advantages when it comes to paying members of S Corp LLCs by structuring group health and retirement plans and that the member can handle income taxes through withholdings versus making estimated tax payments.
“So why wouldn’t we just elect for the new LLC to be an S Corp?” asked Josh. “I thought you would ask that question.” replied Allen.
He explained that one big disadvantage to the LLC S Corp is that members can only deduct losses to the extent of their basis in the LLC. While members in Partnership LLCs gain basis from the LLC’s debt allowing them to deduct losses in excess of their investment, this does not necessarily hold true for S Corp LLCs. Simply guarantying debt in LLC S Corp does not afford the member additional basis. Only loans directly from the member can be considered additional basis.
He also explained that LLC S Corps are limited to treating all members in proportion to their ownership, thus members do not have the option of allocating earnings and losses disproportionate to their ownership. The IRS will look at this as the LLC having multiple classes of stock, a disqualifying factor for the S Corporation election.
“Allen, why do you accountants and CPAs make things so complicated?” asked Josh. With that Allen replied “Yes, I know it can seem complicated. Our job is to educate and guide our customers to make good business decisions. Hopefully you understand the basic differences and feel comfortable with what we have covered.” Josh agreed that he wasn’t an expert, but he felt like he had enough information to make a good decision.
When it comes to making tax and business decisions, it is important to consider how the decision will impact your specific situation. At Porterfield & Company CPA we guide franchise and pharmacy owners to meet their financial goals.
Have questions related to franchise or pharmacy operations? Give us a call at 1-844-309-4930 or contact us via the Email link on the website.