Tax Planning To Help New Franchisees

Even though you take direction from the franchise on marketing materials, training methods, employee rules and suppliers, you still are in charge of the business in ways that the IRS defines as being self-employed. You make your own schedule and establish your own community and business relationships, so the government puts you in the same category as a sole proprietor. That means you need to report your earnings on a Schedule C, just like single-member LLCs and sole proprietors do, and you need to pay the additional 15.3% tax that self-employed people are assessed.

Though this may feel excessive, if you were somebody’s employee they would be taking out payroll taxes on your behalf to cover Social Security and Medicare for your future. That is what the additional taxation is for. Unfortunately, as a franchisee you will have to pay that amount regardless of whether your income ended up in your pocket as take-home pay. Just as is the case for participants in a partnership, it doesn’t matter whether profits are reinvested in the organization or paid out as distributions, they still count as self-employment income and are taxed as such. Keeping this liability in mind is an important part of your financial planning that an experienced tax professional can ensure you have prepared for properly.

One of the advantages of being a franchisee is that you can be either an active or passive participant. Making the decision about whether you are hands-on or simply purchasing the business and handing off day-to-day operational responsibilities to a partner has important tax ramifications. Establishing whether your earnings are passive or active will be one of the first tasks on your tax professional’s list, and they will do this by asking questions like the ones below, which are geared to learning exactly what you do, and to what extent.

• When did you buy this business and how have you interacted with it since then? Franchisees that have materially participated in the business in five of the previous ten years can be determined to be active participants, regardless of their answers to the other test questions they will be asked. 
  
  
• Over the course of the past year, how many years did you actively participate in the business? If your answer is more than 500 hours, the IRS can consider you a material participant rather than a passive one. 
  
  
• How does your participation level in the business compare with others who are involved? If you worked at least 100 hours on the business and no less than anybody else, then you can be considered an active participant.

These are just a few of the IRS’s material participation tests, and it’s an important determination because of the way that passive losses are handled. If you are identified as passively involved, then any losses you realize as a franchisee can only be offset by other passive income. The losses can be carried forward if you don’t have enough income to offset them, but you will never be able to take the deduction of passive losses against wages, active business earnings, or other ordinary income.

If you’re considering buying new equipment or furniture for your business, the Tax Cuts and Jobs Act (TCJA) passed in 2017 gives you a significant, but short-lived tax advantage. Your investment of capital into your business qualifies for a 100% bonus depreciation until the end of tax year 2022. After that, the bonus depreciation level will drop by 20% each year, lowering to 80% in 2023, 60% in 2024, and so on until it is completely gone at the end of 2026.

If you are purchasing a business structure rather than leasing one, other advantages can be realized by having a specialized professional conduct a cost segregation study to separate the cost of a building from expenditures on non-building components such as electrical components, drywall, ceilings, and interior doors. The Coronavirus Aid, Relief and Economic Securities (CARES) Act defined these components as 15-year property, which effectively provided a bonus depreciation period for these expenses. This allowed qualified improvements to the property (QIP) to be deducted over a shorter recovery period as long as their costs are separated from the cost of the building itself. Having a cost segregation study done in support of this depreciation can make a significant difference in your tax liability.

Different types of businesses are eligible for specialized tax incentives, and if you are new to franchising, you may not be fully aware of them. Here are a few that we may be able to identify for you:

• FICA tip credit – Owners of businesses where employees commonly receive tips may be eligible for the FICA tip credit that allows you to claim the difference between the taxes you pay on your workers’ tips and the Federal minimum wage. 
  
  
• Opportunity Zones – Though the sale of a property is generally cause for having to pay capital gains taxes, they can be deferred if they are reinvested into areas that have been identified as opportunity zones. These are economically depressed areas that have been specifically identified in order to promote investment, and if your franchisor permits you to open a franchise in a qualifying area, you will be rewarded by either a deferral of capital gains liability or —if you keep the property and business there long term — potentially eliminating the capital gains liability entirely. 
  
  
• Work Opportunity Tax Credit – If your franchise employs members of groups known to face challenges to being hired, you may be able to claim up to $9,600 for each. The eligible employee groups include ex-felons, food stamp recipients and others, and the amount of the credit is dependent on numerous factors, including the specific targeted group and the employee’s tenure with your organization.

As you can see, the opportunities that come with being a franchisee come with a host of tax regulations that may be unfamiliar and confusing. To set yourself up for success and avoid both confusion and the potential for penalties, contact our office so we can help you navigate and plan for this new world.