How To Choose The Right Legal Structure For Your Franchise

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 much of the groundwork involved in building a business’s infrastructure and systems from scratch.

But even though a franchise location is associated with a larger brand, its owners are responsible for forming a business entity and managing all operations and administration of their location.

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 post:

• What is a franchisor? A franchisor is a company that sells the right to others 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 privately owned business (a franchise) under an agreement with a franchisor.

For example, McDonald’s is one franchisor; the owner of the McDonald’s location in your city is a franchisee.

Franchise and constitution of a business entity

Incorporating a legal business entity provides liability protection for business owners and may provide some tax advantages. The underlying purpose for setting up a franchisor’s entity is slightly different than why it is important to set up an entity for a franchise location.

Franchising 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 protects its owners and the parent company from the franchisees’ legal liabilities and debts.

Consider this hypothetical example: Subway is a franchisor. Let’s say 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 parent franchise entity would be protected.

Franchisors often choose the limited liability company structure for their entity. Technically, a franchising entity can be incorporated in any state. However, it is wise for franchisors to discuss their options with an attorney and tax professional before making a decision.

Franchised entity

A franchised entity is one created by a franchisee when they purchase 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 the documentation can be put in the name of the entity. Franchise entities are usually LLCs. Many franchisors will not allow a company to buy a franchise because issuing shares 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 resides. The physical location of the franchise will require permits, licenses, leases, etc., and therefore the business will need to be registered in that jurisdiction to obtain them.

Name of a franchise entity

Many franchisors create an entity with a name that implies their purpose is to sell franchises, for example, Your Company Franchising Inc. or Your Company Franchise Sales, Inc. This facilitates the differentiation of entities.

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

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

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What about multi-unit franchises?

A multi-unit franchise is when a franchisee buys multiple locations. Typically, the franchisor wants each unit to be established as a separate legal entity with separate DBAs and permits.

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

Entity requirements for franchise companies

In addition to contractual obligations with franchisors, franchisees must meet 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).
• Submit 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.
• Full sales tax registration (usually not applicable to service-based franchises).
• Presentation of licenses and business permits required to legally operate in your location.

Become a franchisee

Curious about what it takes to start and operate a franchise? Here are resources to help you assess feasibility and explore the possibilities:

Starting a franchise business allows you to enter the world of entrepreneurship with built-in brand awareness and established systems and processes. That doesn’t mean it’s completely plug and play, though! Make sure you get the legal and accounting guidance 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 provider of services and resources for business incorporation, LLC registrations and corporate compliance services in all 50 states.