Tax Planning to Help New Franchisees

June 2021

Investing in a franchise can be a wonderful opportunity, but it can also involve a completely unfamiliar set of rules when it comes to your taxes. Whether you are considering becoming a franchisee or have recently become involved, it’s important that you seek the right advisor to help ensure you understand your tax obligations and prepare accordingly. Here are just a few of the things that you need to keep in mind:

Organizing Your Franchise

How you organize your franchise is going to be one of your earliest decisions, and one of your most important. From a tax perspective, your tax advisor can advise on different corporate/unincorporated structures and the tax implications of each. You should also be sure to engage an experienced franchise attorney to review legal documents related to the franchise, lease agreements, and/or bank loans. The attorney can also advise on asset protection strategies based on the organizational structure you choose.

Unincorporated Franchisees Pay Self-Employment Taxes

Even though you take direction from the franchise on marketing materials, training methods, employee rules and suppliers, and many other decisions, you are still 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.

The rules surrounding taxes on self-employed individuals are complicated, and we’ve expanded on this topic in a prior blog.

Are You an Active or a Passive Participant?

One of the advantages of being a franchisee is that you can be either an active or a passive participant. Making the decision about whether you are hands-on or simply purchasing the business and handing off the 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. By answering questions like the ones below, your advisor will be able to understand 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 hours 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 that are used to make this important determination that impacts 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.

It’s important to note that the passive loss rules apply whether you decide to incorporate your franchise, operate as a partnership, or as a self-employed individual.

Be Aware of Eligibility for Specialized Tax Incentives

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 your advisor may be able to help 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.
  • 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 employee. 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.

Why Franchisees Need Expert Tax Advisors

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 us at Cray Kaiser so we can help you navigate and plan for this new world.

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