This paper examines the four primary business entity structures available to restaurant entrepreneurs: sole proprietorship, partnership, corporation, and limited liability company (LLC). The analysis evaluates each structure's tax implications, liability protections, capital requirements, and operational flexibility in the context of the highly competitive restaurant industry. While the LLC emerges as the most advantageous structure for most restaurant ventures due to its blend of liability protection and tax efficiency, the paper concludes that the optimal choice depends on individual circumstances, the commitment level of owners, and the long-term vision of the enterprise. Success in the restaurant industry ultimately depends not only on proper entity structure but also on the passion and competence of the owners themselves.
There are four primary business structures an entrepreneur can employ when opening a restaurant: a sole proprietorship, a partnership, a corporation, and a limited liability company (LLC). Several variables are worth careful consideration when deciding the appropriate structure for a business, including the tax implications, the relationship and goals among owners in an entity, and the extent of capital liability. Moreover, the competitive nature of the restaurant industry places a high priority on ensuring that owners have structured their entity in the best possible way to take advantage of the different benefits associated with each type of structure. Ultimately, long-term success or failure can hinge on the entity's structure.
In the following paper, the benefits and disadvantages of each type of business structure will be explored in the context of the restaurant industry. Additionally, the tax implications for each structure on the participants will be examined, with a careful eye toward the long-term consequences of each. However, it will be revealed here that the highest priority in such a highly competitive and failure-ridden industry is the nature of the co-participants and their relative passion for success. In most cases, a healthy and vibrant passion for the hospitality industry is essential and must be demonstrated by all participants over time. Ultimately, this paper will demonstrate the importance of not merely having the appropriate business structure for tax and liability purposes, but also to meet the vision and goals of the entity.
This is a key element of success in this field. The restaurant industry is renowned for providing opportunities that are risky and rife with pitfalls, and many restaurants fail within one year of opening. A recent study suggests that restaurants have only a 20 percent chance of surviving for two years. Among the most common reasons are shortfalls in capital, improper management, poor quality of food and service, misperception of market base, and over-saturation of the market. Furthermore, anecdotes persist regarding restaurants that have demonstrated proficiency in each of these areas, hired an experienced staff, and poured capital into the business, only to find imminent failure. On the other hand, many successful restaurants have persevered in spite of apparent deficiencies based on location, market trends, or just sheer good fortune. The restaurant industry is therefore known for meting out success and failure in sometimes arbitrary and capricious ways. Some of the most successful restaurant chains and operators have a string of failures in their past, and many in the industry feel that exceptional service is necessary for a restaurant to find success.
On the other hand, the restaurant industry surpassed $450 million in revenue in the U.S. in 2009, making it one of the most productive sectors in the country. Nearly 11 million people are employed in the hospitality sector, equivalent to just over 9 percent of all employed Americans. Though this doesn't correlate to the high incidence of failures among new restaurants, all relevant statistics bear out the fact that American diners continue to have disposable income in spite of the global economic crisis of 2008. There have also been many successful restaurants in recent years, across different types of cuisine and price points. The success stories also cross the various types of ownership structures, which we will discuss in this paper.
A brief examination of each entity type will ensue, including a demonstration of the merits and drawbacks of each in business. These aspects will then be applied to the restaurant industry, with a focus on the various types of restaurants (such as franchise ventures, mom-and-pop diners, and upscale dining establishments). It will become clear that, while the decision regarding business structure is extremely important, in many cases there is no clear-cut correct answer. Therefore, the long-term vision and goals of the entity frequently are the most important variable in making this determination. Finally, we will conclude with an analysis of the future prognosis of the restaurant industry, and the basic framework and attributes of successful entrants across business structures.
The most basic form of business ownership is the sole proprietorship. The sole proprietorship is an unincorporated company that is solely owned and operated. It is the simplest to establish and run, requiring only the state and local licenses necessary in the relevant field and typically requiring no annual dues or maintenance fees. The tax structure of a sole proprietorship is similar to personal taxes, insofar as all profits and losses are reflected in personal financial statements. Therefore, the sole proprietor is responsible for claiming and paying all tax accountability themselves, just as anyone who is self-employed. The sole proprietor has no indemnity for losses and assumes all of the risk associated with the business format. Therefore, any existing creditors can demand that personal assets cover business-related losses. Also, the limits on equity are completely related to the equity of the proprietor. In other words, the start-up and operating costs, which can be high in the restaurant business, are a product of the financial viability of the proprietor alone.
Sole proprietorships are the oldest and most traditional form of ownership in the restaurant industry. They are most common in smaller mom-and-pop, family-owned restaurants, and have had a great deal of success. They offer the benefit of complete control of operations and power over day-to-day business decisions. In a business in which success is frequently driven by passion for the business and for hospitality, sole proprietorships allow for personal drive to be a primary determinant regarding financial success or failure. They are preferable for eliminating the need to work with other individuals and allow a solitary person to execute a vision on a daily basis without the need to consult with someone else. Therefore, the benefits are mostly psychic and personal, though these can be substantial enough to see the business through to success.
There are additional economic benefits to sole proprietorships, including the certainty that dividends will not be taxed both as personal and business-related income, also known as double taxation. In a sole proprietorship, the owner benefits from all of the profits and suffers all of the losses. Profits are taxed as personal income and business expenses are deductible.
In a business where the doors open nearly every day, this means the sole proprietor signs every check to pay for the continual purchase of the fresh ingredients necessary to serve food, drawing on the funds from their own bank account. It also means that every dollar in profit margin—represented by bodies in chairs and plates in the kitchen window—finds its way to the same pool of resources from which the checks are drawn. A key element of choosing this solitary model of ownership is the tolerance the individual has for bearing every penny of economic pressure. It is therefore worth noting that the sole proprietorship is increasingly being passed over in favor of business structures that diffuse risk and which offer limited forms of liability.
General partnerships are unincorporated business structures in which two or more entrepreneurs enter into business for the purpose of generating profit margins. Partnerships do not have the advantage of limited liability protection. However, they spread the risk across all owners involved in the entity, diffusing the burden that any individual owner would assume. The joint accountability refers also to the personal assets of each partner. Additionally, each partner is accountable for profits, losses, and deductions to be reported on personal income taxes. Therefore, the partnership itself is not taxable; it is merely a tax-reporting entity.
Limited partnerships are possible in which general partners and limited partners each provide capital to the entity. This reduces the start-up costs associated with the entity. It also facilitates the combination of experience and management skills of a variety of entities and people, which can lead to better decision-making and more rational choices over the long-term lifespan of the business. However, limited partners are typically not permitted to exert control or manage the business on a day-to-day basis. The liability of the partner is also limited, usually to the amount of their investment. In other words, a limited partner cannot be hurt by the mismanagement, negligence, or malpractice of other owners beyond the investment capital already contributed to the entity.
Effective partnerships require an uncommon confluence of economic and personal circumstances, and for this reason they are the least common of the entrepreneurial structures discussed here in the restaurant industry. It can be difficult to find appropriate partners for the scope of the project, insofar as their qualifications are based on economic and personal factors. Not every business owner can accept the limited role associated with partnerships, and personality conflicts can arise. In the restaurant business, owners are typically passionate and single-minded, and many cases exist in which financially complementary owners do not mesh philosophically. In partnership, an individual owner can make binding economic and operational decisions that affect the other owners. Also, the profits enjoyed by a business may not be suitably substantial when spread across multiple owners.
Partnerships demand that all partners (both general and limited partners) be on the same page financially and within the scope of the business operations. They require a shared goal and vision for the entity, and a mutual understanding of each owner's role and the parameters for exerting control. Perpetual lines of communication must be available for all parties in response to changing dynamics and the occurrence of unforeseen events. This is particularly relevant in the restaurant industry, where consumers have many choices and often make them based on little substance. The restaurant industry is fraught with sudden changes, which can require added attention, effort, and capital in a short period of time. Therefore, a thorough understanding of the roles of each owner, be they a general or limited partner, is essential to a properly functioning partnership.
Additionally, effective partnerships require regular meetings and reviews of all business operations, and a careful understanding of profits and losses. The profits and rewards of the business have to be clearly defined and real to each member; the losses have to be well-reasoned and explicable. Both must be allocated fairly in accordance with the business plan established prior to setting up the partnership. In other words, individual partners should not reap artificial rewards or suffer disproportionate losses without the complete understanding of all ownership parties. Finally, there should be a concrete and clearly defined period of time for all expectations relating to the realization of profit and the expectations of the partners. Performance and time frame matters should be addressed regularly in meetings and reviews conducted within the framework of the potentially fast-changing business. It is recommended that all of this be written down in advance in the form of an agreement that details every aspect of the business. This agreement should be signed by every party and considered a legally binding document. These steps enhance the likelihood that the partnership will survive the tumultuous climate that prevails in the restaurant industry.
The corporation is distinguished by its treatment as a separate entity from stakeholders and owners for tax purposes. The corporation itself pays taxes on profits, as opposed to the individual investors. Essentially, the corporation facilitates the collection of capital from individual owners for the purpose of entering into a business venture. Corporations provide the benefit of easy and open transfer of ownership. Also, the lifespan of a corporation is perpetual, rather than lasting until the death or illness of a sole proprietor or all of the relevant partners. This is because the corporation exists as a solitary, legal, and independent enterprise, with the power to carry assets or liabilities on its own.
Importantly, corporations offer the advantage of limiting asset liability to the amount of the individual capital investment, as opposed to the full liability in a proprietorship or partnership. Because this is true, individual minority owners have limited power in controlling the day-to-day business operations. The majority of stakeholders typically determine the course of the business. However, the management structure of the enterprise can fundamentally change without altering the structure of the corporation. Also, the credit resources of the owners can be limited due to the limits placed on liability. On the other hand, the larger number of participating owners typical for a corporation can imply easier means for generating capital when the need for capital arises. One final advantage of incorporation is the fact that corporate tax rates tend to be lower than individual rates.
However, corporations have several disadvantages, including the difficult and time-consuming nature of creating one. This is largely because of the many state and federal requirements that owners must fulfill. Also, state boundaries often prevail, leading to additional requirements for businesses wishing to conduct business operations across state lines. Corporations require that an Articles of Incorporation be documented and registered with state and federal authorities. The Articles must include the rules and bylaws of the corporation, and filing fees must be paid in accordance with registration guidelines. Additionally, stock certificates must often be issued for public corporations, which requires additional bookkeeping and accounting personnel. Finally, typical corporate structures do not provide the benefit of shielding income from taxation at the corporate and personal levels.
However, alternative corporate structures exist that do shield stakeholders from double taxation, including companies preferring to be taxed under Subchapter S of the Tax Code (or S Corp). An S Corp offers the advantage of allowing income to be taxed only at the shareholder level, so that corporate revenues are not collectively taxed. S Corps have restrictions relating to the number of permissible shareholders and the ownership of subsidiary companies. However, these regulations are rarely applicable in the case of restaurants, except in the case of very large, multinational corporations. S Corps are therefore preferable to standard forms of corporate ownership in most cases with respect to the restaurant industry. However, they lack the flexibility of limited liability companies.
An LLC essentially combines the structures of a corporation with that of a partnership. It protects stakeholders from the liability of personal assets, while also offering the tax benefits inherent in a partnership. Specifically, this refers to the advantage of having income taxed only at the personal level. In other words, the LLC bears no obligation to pay federal income taxes. Members of an LLC can deduct their business expenses on their personal taxes with respect to their share of the entity's debts. Also, the requirement of holding regular meetings or issuing stock certificates is obsolete. Once the enterprise's agreement is established and registered, there are very few obligations, which typically benefits operating members and minority stakeholders alike. Operations can be designated to specific LLC members or to independently hired managers without the need to restructure the company. Finally, the LLC offers the advantage of allowing dividends to be spread unequally across the various members. Corporations require that profits be spread equally. This allows resources to be allocated based on the needs of the members. These circumstances pose many benefits to owners in the restaurant industry, and so they have grown in popularity over the previous ten years.
Ultimately, the LLC is the most likely platform for success in the restaurant industry, because it most effectively takes advantage of the tax code while effectively distributing risk across many investors. It allows the cumulative resources of many entrepreneurs to carry enough weight to frequently let the merit of the entity determine success or failure. It reduces the potential need to assume business loans that can hamper the entity down the line. It frequently places the financial burden on paying down a mortgage over the course of 15 to 30 years; or it places the challenge squarely on meeting the terms of a lease as a part of fixed business costs. Either way, it is the structure that most capably curbs the arbitrary and capricious nature of the restaurant industry. Among the various business structures available to the restaurant entrepreneur, the LLC most frequently returns the power of self-determination back in the hands of the ownership group, which is how most entrepreneurs wish to be judged.
The best business structure for a restaurant depends on a variety of factors, and must be determined on a case-by-case basis. While the LLC offers the most benefits to the most forms of ownership groups, it is inaccurate to say by default that it is the most attractive structure. LLCs and corporations carry with them the responsibility of effective management of operations to be delegated to the appropriate member or members. These individuals are legally bound to act in the interest of their fellow members in the name of loyalty, fairness, and duty. This requires a very thorough understanding of the legal aspects of the duties of directors, a meticulous record of all business activity, and open lines of communication among members. These dynamics are not possible in every situation, and are reasons why the LLC and corporation are not the ideal structures in the case of each entity.
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