Should Franchisors Require Franchisees to Incorporate?
Franchisors provide varying levels of assistance to new franchisees for the startup of a franchised business. Typically, they will assist with site selection and construction, on-site training, opening and management, human resources (HR), manuals and guidelines, local marketing and advertising. However, very few Canadian franchisors help the franchisee choose the legal form his or her business will take. This article explores the issue of whether franchisors should require franchisees to incorporate, and if so, what assistance they should provide.
Sole proprietorship and general partnership
A sole proprietorship is an unincorporated business owned by one person, with no existence apart from its owner. The owner is responsible for all business decisions and earns all the profits, but also assumes all risks and obligations. Sole proprietorships are easily formed and dissolved, with startup costs under $100.
General partnerships are relationships between two or more persons carrying on a business with a view to making a profit. Aside from having multiple owners, this form differs little from a sole proprietorship.
Corporations have legal personalities distinct from both their owners (shareholders) and the individuals who manage their affairs (directors and officers). Corporations are created after articles of incorporation have been properly filed with the government or another authoritative body.
Occasionally, a franchisor will require franchisees to incorporate their new businesses. In these cases, the franchisor often insists on forming 'numbered,' rather than 'named' corporations. The title of a named corporation is selected by its founders, e.g. 'Tiger Computers, Inc.' A numbered corporation is one for which the government assigns only a number, e.g. 'c123456 Canada, Inc.,' as it legal name.
Even when the franchisor desires franchisees to incorporate, there is often no set method put in place. When asked for guidance, some franchisors simply advise franchisees to consult a lawyer, accountant or government official. Others leave it entirely in the franchisee's hands. This lack of guidance has drawbacks for both parties.
The franchisor's preference
Franchisors who choose to incorporate franchisees gain several advantages.
Franchise systems operate more efficiently when all franchisees have the same legal form. To improve communication and internal tracking, franchisors may add numbers or territorial designations to the franchisee-corporation's legal name. They could also require franchisees to have identical fiscal year-ends to assist financial reporting, data collection and franchise-wide benchmarking.
While an unincorporated business may provide similar financial data to franchisors, sole proprietorships must have a December 31 year-end. If some franchisees are incorporated and other are not, and if there is a variance on the fiscal year-end, this may complicate the data-gathering process.
As distinct 'persons,' corporations are not dependent upon the lives of their shareholders, directors or officers and will not be affected by deaths or retirements of members. This flexibility benefits franchisors in that business will not be interrupted should an owner unexpectedly die.
If the franchise is a sole proprietorship and the franchisee dies, transition will certainly be more costly and cumbersome. Property has to be re-titled, new contracts drafted and other administrative steps taken any time the slightest change of ownership occurs. This can be an important issue in situations where the franchise needs to be sold quickly.
Transfer and sale
Should a franchise unit need to be sold, incorporation allows for a more orderly and timely transfer of ownership. While there will always be some changes, there is rarely a new lease to sign, new bank accounts (only a change of signing officers) or new government tax account numbers to apply for.
The drawbacks of incorporation
The advantages of incorporating a business generally outweigh the drawbacks. However, the following downsides must be considered.
Additional cost of incorporation
Business formation costs are always borne by the franchisee as a cost of doing business. Government fees for sole proprietorships range from $30 to $100, but between $200 and $360 for incorporation. Further incorporation costs include disbursements, e.g. name reports, minute books, etc., and professional fees ranging from $100 and $1,000. These additional costs are one reason franchisors do not require incorporation.
Additional maintenance costs
Maintaining an incorporated business involves costs beyond what sole proprietorships must deal with.
- Separate income tax returns to prepare and file. The incorporated business is distinct from its owner, meaning income tax returns have to be filed for the business as well as for the individual; and
- Additional government filings to prepare and administer. The annual return must include any changes to the company made during the year or during the annual general meeting. These could be changes in directors, officer positions, the company's address, etc. Government fees for filings are typically inexpensive. For example, Ontario charges $22, British Columbia, $35 and Alberta, $50. In only three provinces does the fee exceed $50.
Making incorporation a requirement
Typically, franchisees do not have a problem incorporating their franchises, even if required to do so by the franchisor. When resistance occurs, it is typically related to costs. Should one decide to make incorporation mandatory, it can be included as part of the franchisee agreement.
Requiring existing franchisees to incorporate is more complicated than having new franchisees incorporate. Existing franchisees have contracts which likely do not account for a forced change of legal structure. Having new franchisees absorb the extra cost of incorporating is entirely acceptable, since they are aware of this cost before signing any franchise agreement. Existing franchisees may be less willing to pay for services they never signed on for.
While most professionals advise their franchisee clients to set up a corporation at some point, they may suggest delaying it based on the client's circumstances. For example, a franchisee who is an un-discharged bankrupt would be prohibited from forming a corporation or being a director of a corporation. Likewise, a franchisee found guilty of a fraud-related crime in the last two to five years would be prohibited from being a corporate director. Of course, these situations are quite rare.
Engaging professional help
Franchisors may wish to establish a business relationship with a professional service provider specializing in franchisee incorporations. This gives the franchisor added confidence that all government filings will be properly submitted.
By creating such a framework for franchisee incorporation, the franchisor and franchisees also benefit from having all business formation work done in a uniform and standardized fashion. Furthermore, such a service may work to complement the franchisee lawyer's counsel and advice. Using a dedicated professional service provider can be both practical and financially sound. However, the franchisor should not prohibit franchisees from using their own lawyers to incorporate, as people often feel more comfortable with their own counsel.
Lionel J. Perez is a lawyer specializing in corporate law and also president of CorporationCentre.ca, a company that develops turn-key franchise business systems for franchisors. He can be reached by phone at (866) 906-2677 or via e-mail at email@example.com.