QUESTION: I am considering buying into a franchise business — eventually seven locations with three to four employees each. What's the best way to structure my business, factoring in personal risk, taxation and costs? If I organize as a corporation, will I be required to pay Medicare, unemployment insurance and Social Security on my employees?

ANSWER: Franchise contracts dictate many things — but not, typically, the legal structure for the business. So you're correct in thinking that — just like any small-business owner — you need to be strategic about picking the one that best suits your needs. Needless to say, before making any bold moves, it's a good idea to check with an accountant or an attorney about which ownership structure is best.

The vast majority of small businesses start off as sole proprietorships, the easiest and least expensive form of ownership to organize. If another person is involved, a partnership is used. Either way, the profits from the business flow directly through to the owners' personal tax returns. The biggest drawback? The owners are personally liable for business debts and court judgments.

Two other options are to form a limited liability company (LLC) or a corporation. Both take time and money, but entrepreneurs in the franchise business often prefer such entities because of the protection they provide. The LLC, in particular, has soared in popularity among franchisees, according to Steve Hockett, president of FranChoice, a franchise referral consultant group in Eden Prairie, Minn.

With an LLC, the owner's liability is generally limited to how much he or she put into the business. The structure also allows for so-called "pass-through" taxation, meaning the profits from the business aren't taxed as a separate entity but are reported on the owner's personal tax returns. This essentially streamlines the tax process, making it possible for an owner to avoid double taxation — one for the business, and one for personal income. With an LLC, "you get the best of both worlds — you get the liability coverage, and the more favorable tax treatment," Hockett says. If you have multiple owners, there's also flexibility as to how you divvy up management and operational duties.

If, on the other hand, you form a corporation, the owners become shareholders who elect a board of directors to oversee major decisions and operating procedures. (Many states allow smaller corporations to operate in a less formal manner). It's a separate entity, so owners aren't personally responsible for debts or lawsuits related to the corporation.

There are two main types of corporations — C corporations, where profits are taxable to the corporation, and S corporations, where profits are reported on shareholders' personal income tax returns.

Business owners who form C corporations are subject to the dreaded "double tax" trap. That's because profits are taxed at the corporate level, and then again when they are paid out to individual shareholders in the form of a dividend.

There are some distinct advantages, though, when it comes to C corporations. For instance, if you want to keep some profit in the corporation, rather than paying it out as salary or bonuses, the money that is retained may be taxed at a lower corporate rate than what an individual would pay. 

Some business owners prefer to set up an S corporation, which, similar to an LLC, allows profits and losses from the business to be reported on the owners' personal tax returns. Here's a difference, though: With an S corporation an owner would pay him or herself a salary, subject to payroll taxes. Then, any additional profit can be distributed as a dividend, free of employment taxes. That could amount to a significant tax savings — as long as the salary is reasonable. "The IRS does look," says Steve Chapski, a Detroit-based certified public accountant who advises small businesses. "You have to watch it, and make sure you are paying yourself the right amount of money."

One last thing, regarding employees: It doesn't matter if you organize the franchise as a sole proprietorship, a partnership, an LLC or a corporation. You still are obligated to pay Medicare, unemployment taxes and Social Security if you have employees, no matter what the corporate structure.