What is the best entity type for my Franchise? (10 Minute Read)
What is the Best Entity Type for my Franchise?
Allen replied “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. We consider every franchise owner’s their specific financial needs before forming the entity to own and operate their franchise operation” stated Allen.
Josh took a deep breath and settled down a bit. His excitement about owning his franchise operation was dampened slightly by how involved the process was. Working in large corporation over the past 12 years, Josh knew that things don’t just happen overnight.
Josh used a fraternity brother that was a CPA to prepare his taxes, but he met with Allen a month earlier 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 began to see that owning a franchise operation adds complexity to his financial and tax situation. While his fraternity brother knows individual taxes, he needs the expertise and experience in franchising that Allen’s firm brings to the table.
Allen recommended that Josh form a corporation or limited liability company (LLC) to own and operate the franchise operation. Both offer liability protection to the owners, but LLCs are generally favored over corporations for a few reasons. First, LLCs are easier to form and maintain. 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 continued explaining the 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 status determines 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 limit owner liability risks and is better from a taxation standpoint.
Single Member LLCs
“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 don’t we just form a Single Member LLC?” asked Josh. Allen continued explaining that if a franchise has few if any employees and the owner is working in the operation, the SMLLC can be a good solution.
Before deciding 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 tells Josh that while SMLLC members can generally deduct losses, taxable income from the SMLLC is generally subject to self-employment taxes (FICA and Medicare) subjecting the franchisee to higher federal taxes than other options.
Josh, thought about those questions. He plans to have 15 to 20 employees including a manager that will run the day-to-day operations. The franchise is being 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 continued discussing 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 from the beginning of our conversation.”
Allen stated, “Josh, when there are two or more owners, an 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 they contributed to the LLC. This really benefits franchisees with existing profitable units when starting additional units that are debt capitalized.”
Allen went on to explain that partnership taxation 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 partners are not 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 seems more complex, but it also seems to fit Josh’s circumstances. He is planning to open 5 locations over the next few years. Although the operations will 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.
S Corporation LLCs
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 like 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 passes 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 including the structuring group health and retirement plans. Members can handle income taxes through withholding versus making estimated tax payments, too.
Understanding Some Differences
“So why not elect for the new LLC to be an S Corp?” asked Josh. “I thought you would ask that question.” replied Allen.
He continued explaining 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 hold true for S Corp LLCs. Guarantying debt in LLC S Corp does not afford the member additional basis. Only loans directly from the member are considered additional basis.
He also explained that LLC S Corps are limited to treating all members in proportion to their ownership, thus eliminating the option of allocating earnings and losses disproportionate to ownership. The IRS looks at this as the LLC having multiple classes of stock disqualifying the S Corporation election.
Making a Decision
“Allen, why do you accountants and CPAs make things so complicated?” asked Josh. With that Allen replied “Yes, seems complicated. We 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.
Porterfield & Company CPA, PLLC
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.