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Should Franchises be Incorporated?

Guest post by: Lionel Perez

Article Overview: Purchasing a franchise can be one of the most exhilarating ventures a small business owner can experience. There are an infinite number of issues that franchisees must consider - what kind of franchise to purchase, where to locate, where to find financing, how to build the space, to name just a few. One of the last questions that a franchisee often thinks of is - what legal form should a franchise operate as? This article will review the considerations regarding the selection of business legal form with the franchise in mind and whether franchisors should consider requiring all franchisees to incorporate.

Should Franchises be Incorporated?

Purchasing a franchise can be one of the most exhilarating ventures a small business owner

can experience. There are an infinite number of issues that franchisees must consider - what

kind of franchise to purchase, where to locate, where to find financing, how to build the space,

to name just a few. One of the last questions that a franchisee often thinks of is - what legal

form should a franchise operate as? This article will review the considerations regarding the

selection of business legal form with the franchise in mind and whether franchisors should

consider requiring all franchisees to incorporate.

Legal Forms Defined



In Canada, there are three basic legal forms: sole proprietorships; partnerships and

corporations.

The sole proprietorship is the simplest legal form. A sole proprietorship is an unincorporated

business that is owned by one individual. The business has no existence apart from the physical

owner. This owner is responsible for making all of the business decisions, earns all the profits,

but also assumes all of the risks and obligations. Most sole proprietorships tend to be small and

localized. Sole proprietorships are easy to start and dissolve and have modest start-up costs

(under one hundred dollars). Sole proprietorships are required to register the trade name it is

operating under with the provincial government business or corporate registry. This is

sometimes referred to as a "Business Registration", "Business Name Registration" or "Doing

business as (DBA)".

A general partnership is a relationship between two or more persons carrying on a business

with a view to making a profit. It shares many of the characteristics of a sole proprietorship

except that it has more than one owner. A partnership agreement is typically signed regulating

the relationship and detailing the sharing of profits and liabilities. As its characteristics are

similar to sole proprietorships, we will only refer to sole proprietorships which can by and large

be applicable to partnerships.

A corporation (also called "company") is a legal entity that has its own legal personality which is

distinct from its owner (or owners) called shareholders, and the individuals who manage and run

its affairs and business, called directors and officers. The creation of a corporation occurs

following the proper filing of Articles of Incorporation with the relevant government department

or authority. In practicality, in small businesses the same individual is the owner/shareholder

and manager/director/officer.

Legal Form Considerations

Limited Liability

One of the most widely known advantages to incorporating a business is the limited liability

conferred upon its shareholders. The shareholders are not liable, in almost all cases, for the

debts and other obligations of the corporation. In other words, there is a liability barrier created

between the corporation and its owners so that if the corporation cannot meet its liabilities, its

creditors are prevented from going after the owners' personal assets.

Sole proprietorships do not benefit from limited liability and this is often perceived as a

significant disadvantage. The owner is personally responsible for all of the debts and obligations

incurred by the business as well as for the actions of employees in the course of their

employment.

This apparent significant difference may in fact be more theoretical than anything else,

especially in the franchise industry. The reason for this is that where a shareholder personally

guarantees a corporation's obligations, as is the norm with franchisors and banking institutions,

the legal protection of limited liability is severely curtailed, if not rendered irrelevant. As such, the

only sheltering of personal assets would towards (minor) creditors that do not have a personal

guarantee from the shareholders.

Tax Treatment Comparison

For the reason outlined above regarding limited liability, many franchisees may be more

interested in a corporation for its tax treatment than for its potential liability protection. While an

in depth analysis regarding the tax treatment regarding corporations and sole proprietorships is

beyond the scope of this article, it will nonetheless outline their major differences.

The owner of a sole proprietorship includes the income and expenses of a business on his or

her personal tax return. Even if the franchise is mildly successful, the business owner can

quickly reach the maximum personal tax bracket and pay income tax at the highest tax rate.

On the other hand, a corporation is taxed separately from its owners and generally at a lower

tax rate. The most striking tax savings is available by taking advantage of "small business

deduction" rates, which are significantly lower on the first $300,000 of active business income.

The small business tax rate in Ontario, for example, is currently just over 17% which is less than

half that of an individual in the highest tax bracket (46.4%, again in Ontario) on the first

$300,000 of taxable income.

There is one caveat however, in that if you start drawing the corporation's income as dividends

this tax benefit begins to erode because dividends are also taxed at the shareholder level. The

double taxation (corporation and shareholder) will essentially result in zero tax savings over a

sole proprietorship. In other words, trying to save taxes by incorporating may make most sense

if you do not need all of your business income to live on and are able leave money in the

corporation.

One way to diminish this effect is for owners to split the dividend income by making a spouse or

children (over 18 years of age), whom are in a lower tax-bracket, shareholders and paying them

a portion of the dividends thereby reducing the aggregate income tax paid. If you have children

under 18, you can still split some income by putting them on the company payroll and paying

them a reasonable salary in view of the services performed. Again, if they have no other

income, that portion can be taken out effectively tax free.

Moreover, a corporation, as opposed to a sole proprietorship, does permit some measure of tax

deferral, since the owners decide when to pay out dividends. For example, a corporation may

pay a dividend in January of any given year enabling the shareholder to pay taxes only in the

following personal tax year.

One of the greatest tax advantages of corporations over sole proprietorships is that when you

sell a small business corporation, the first half million of capital gains is tax-free for each

shareholder. This one time tax benefit is only available if the business is incorporated. This may

be an appealing exit strategy to franchisees who intent to build a franchise and cash out a few

years thereafter.

These are only some of the flexibilities that are afforded to corporations. Some other items to

note include: paying a bonus to reduce income below the $300,000 small business deduction

rate thereby increasing a corporation's expenses and lowering its income; issuing a loan to a

shareholder where it would be "paid back" by way of a future dividend in the corporation's

following fiscal year effectively deferring such income tax for almost two years; and, a

corporation's ability "carry forward" losses thereby offsetting any losses in one year against

profits in subsequent years. This can be particularly advantageous when a franchise is

anticipating losses in its first year or two of operations and all personal income is only generated

from the franchise.

Perpetual Existence



Another feature particular to corporations is that since it is its own legal entity, it is not

dependent upon the life of its shareholders, directors and officers and will not be directly

affected by changes in, deaths or retirements of its members.

This advantage allows for the orderly sale and transfer of ownership of the corporation (i.e., its

shares). While there will always be some changes, there is no new lease to sign, no new bank

accounts (only changing of signing officers) or government tax account numbers to apply for,

thereby minimizing the effect on the franchise operations. If the franchisee is a sole

proprietorship and passes away, the transition is guaranteed to be more difficult. The process of

divesting ownership in proprietorships (and partnerships) can be cumbersome and costly.

Property has to be retitled, new contracts drafted, and other administrative steps taken any time

the slightest change of ownership occurs. This may be an important advantage in situations

where the franchise needs to be sold, potentially eliminating or at least reducing difficulties.

Costs and Obligations

One of the most commonly professed disadvantages of incorporating a business is that is has

higher start-up and maintenance costs than sole proprietorships. These higher costs include

higher government incorporation fees, professional fees (lawyers and accountants) related to

the start-up, as well as, annual professional and maintenance fees (filing separate tax return for

the company and the individual, preparing of corporate resolutions). While there is no doubt that

incorporating a business is more expensive than registering a sole proprietorship, the actual

cost has been significantly reduced due to the emergence of the Internet and new professional

legal and accounting service providers in this marketplace.

Corporations do have more formalities than sole proprietorships. In addition to more

government and administrative filing requirements, there are many other internal formalities

corporations must undertake. A corporation must keep internal records for important decisions

that are made by its directors and shareholders. The decisions are recorded and kept in the

corporation's minute book along with all other important corporate documents. Failure to comply

with these requirements may lead to fines or being stricken from the corporate registry.

Franchisor Preference

Should franchisors care whether franchisees incorporate? There may be a number of

considerations that lead franchisors to require that their franchisees be incorporated.

As mentioned earlier, requiring franchisees to incorporate may simplify any sale or transfer of a

franchise. If for some reason the franchise needs to be sold, a corporation could allow for a

more orderly and timely transfer of ownership.

Additionally, having only one type of business structure may streamline franchisor operations.

Franchisors may assign franchise numbers or territory as part of the franchisee corporation's

legal name to more efficiently communicate with them and track them internally.

If franchisors were to require franchisee incorporation, they may do so by including it as part of

their franchisee package. This could in turn provide greater assistance to franchisees by

facilitating the business formation process. Franchisors provide varying levels of assistance to

new franchisees regarding the start-up of a franchise business. Why not business formation?

Currently, most franchisors have no requirements whatsoever and leave it entirely up to the

franchisee to decide how to operate. Some franchisors, although few, do require that all their

franchisees incorporate their new businesses, but do not assist them in this endeavour.

Franchisors could establish a business relationship with a dedicated national incorporation

professional service provider to handle all franchisee incorporations helping franchisees save

time, money and frustration. Franchisors would have the added confidence that all government

filings would be properly filed.

By creating such a framework for franchisee incorporation, the franchisors and franchisees also

benefits from having all the business formation legwork done in a uniform and standardized

fashion. No more waiting for the incorporation documents to proceed with the signing of the

franchise agreement. Furthermore, such a service may work by complementing the franchisee

lawyer's counsel and advice. From the perspective of standardizing franchisee incorporation,

using a dedicated professional service provider may be both practical and financially sound.

However, the franchisor would be wise not to prohibit the franchisee from using his or her own

lawyer to incorporate.

Any professional familiar with the franchise industry can attest that every franchisor-franchisee

relationship is different. Accordingly, there are a number of variables that must be considered,

as well as the particular circumstance of the franchisor and franchisee before selecting a

business structure or requiring a franchisee to incorporate. In general, most professionals

advise their clients to set-up a corporation at some point in their business operations. The

determination of if and when to incorporate is best decided on the counsel of trusted

professionals.

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