How to Choose the Right Legal Structure for Your Franchise
The franchise model of doing business streamlines the entrepreneurial process. By operating as a franchisee, you can become a business owner without much of the preliminary groundwork involved in building a company’s infrastructure and systems from scratch.
But even though a franchise location is associated with a larger brand, its owners hold responsibility for forming a business entity and managing all of the operations and administration at their site.
In this article, I’ll 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 refer to throughout this post:
- What's a franchisor? A franchisor is a business that sells the right to others to open stores or sell products or services using its brand, expertise, and intellectual property.
- What's a franchisee? A franchisee is an individual or business entity licensed to operate their privately owned business (a franchise) under an agreement with a franchisor.
For example, McDonald's is a franchisor; the owner of the McDonald’s location in your town is a franchisee.
Franchising and forming a business entity
Forming a legal business entity supplies liability protection to business owners and may provide some tax advantages. The underlying purpose for setting up a franchisor’s entity is slightly different from why it’s important to set up an entity for a franchise location.
Franchisor entity
A franchisor forms an entity to sell rights to franchisees to open and operate a franchise location using the franchisor’s brand, 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 liabilities 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’s location. The individual would sue the local franchise business, and the main franchising 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’s wise for franchisors to discuss their options with an attorney and tax professional before deciding.
Franchisee entity
A franchisee entity is one set up by a franchisee when purchasing the rights to operate a local franchise. Many franchisors will require the franchisee to set up their entity before drafting contracts or a Franchise Disclosure Document (FDD), so the paperwork can be put in the entity's name. Franchisee entities are usually LLCs. Many franchisors will not allow a corporation to purchase a franchise because the issuance of stock would have significant legal and tax implications.
A franchisee should almost always register its entity in the state where it has its physical presence, regardless of where the owner’s residence is. The physical location of the franchise will require permits, licenses, lease agreements, 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 easy to differentiate entities.
As for franchisees, they may use the franchise’s brand name for marketing purposes by establishing a DBA (a fictitious name). However, their legal entity’s name must not include the name of the franchise being purchased (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 might instead set up DBAs like “Subway Store #1234” or “Burger King Woodland Hills.” Franchisors usually have a specific way franchisees should format their DBAs.
What about multi-unit franchises?
A multi-unit franchise is when one franchisee purchases multiple locations. Typically, the franchisor will want each unit set up as its own separate legal entity with separate DBAs and permits.
In some cases, franchisees can start a parent company that holds all their entities beneath it to keep things simple. However, this only works if the franchises are all owned by the same people.
Entity requirements for franchised businesses
In addition to the contractual obligations to franchisors, franchisees must comply with federal, state, and local requirements when setting up their business entity:
- File formation paperwork 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 corporate bylaws).
- Register for payroll tax and other employment-related taxes.
- Complete sales tax registration (usually does not apply to service-based franchises).
- Filing for any required business licenses and permits to operate legally at their location.
Becoming a franchisee
Are you curious about what it takes to start and operate a franchise? Here are resources to help as you assess the feasibility and explore the possibilities:
Starting a franchise business lets you enter the world of entrepreneurship with built-in brand awareness and established systems and processes. That doesn’t mean it’s entirely “plug and play,” though! Make sure you get the legal and accounting guidance you need to ensure it’s the right fit for you.
