Which Business Structure Is Right For You?
While you are considering the purchase of a franchise, you should also begin a process, in parallel to your search, that addresses your financial and tax considerations. Your consultant will generally suggest you begin interviewing small business accountants and financial consultants so that you may have a relationship developed when you’re ready to start your business – but more importantly, so that you’ve had conversations with these experts that will allow you to think through various issues important to HOW you start up your business. If you wait until after you purchase your franchise to have these conversations, it may cause unnecessary delays in your ability to start up your business – and as you know, time is money in the world of business. These issues usually have to do with how you should structure your business, how you finance your purchase, and the tax implications of your franchise purchase. Only your accountant or financial consultant can best answer the latter two issues for you, but we can address structure for you here.
The most common business entity structures are:
• Sole proprietorship
• Limited Partnership (LP)
• Limited Liability Corporation (LLC)
How do these structures compare? And on what factors do they differ?
The most common factors in which these structures differ is your company’s liability protection under each particular structure, and the tax requirements. There are also differences with regard to complexity and cost of formation, as seen in the following chart:
|Complexity||Type||Formation Cost||Taxation||Liability Protection|
|Very Low||Sole Proprietor||Low or Zero||1 level||None|
|Low or very low||Partnership||Low||1 level||None|
|Medium||Limited Partnership||Medium||1 level||Good|
|Medium||LLC||Medium||1 level||Good to Very Good|
|Medium to High||S-Corp||Medium to High||1 level||Good to very Good|
|Medium to High||C-Corp||Medium to High||Corporate (2tier)||Very Good|
Most attorneys or accountants will tell you to consider an LLC, an S-Corp, or a C-Corp structure, as these offer your company greater protection against personal liability.
Right off the bat, you can see in the above chart, that C-Corp is somewhat less desirable from a tax perspective, but strong from a liability standpoint. Similarly, the most popular choices – the S-Corp and LLC — seem absolutely comparable – but are they? The tie-breaker usually is something called “self-employment taxation.”
The Federal tax imposed if you are “self-employed” is 15.3%. (12.4% is Social Security tax paid on first $94K, and 2.9% is Medicare tax paid on all income.) And half of this self-employment tax is deductible on your personal return.
If you are an LLC, you are required to pay SE tax on the entire income generated by your business. An S Corporation only pays SE tax on the owner’s salary, not distributions. (Example: Against $100K in income, an LLC owner will pay about $43K in taxes while an S-Corporation owner will pay about $38K in taxes.) In addition, an S-Corporation allows owners to build a pension (412i) that can provide significant tax advantages as well as build personal equity.
Another important point to consider is that an LLC can often have advantages in cost of formation, i.e., there can be fewer documents required or a lower attorney fee, and can be slightly simpler to maintain. This tends to be a state-by-state consideration.
In net, it’s important to have your accountant compare the SE tax based on your business plan for either structure AND the comparative costs of formation in your state.
Other financial considerations you may want to discuss with both your consultant and your financial expert are impact on estate planning, timing of purchase (and the impact on franchise fee tax deductions,) and your exit strategy. The better and earlier you understand these basic financial issues, the more you can concentrate on building your business!