Investment can be an excellent opportunity, but it also involves an entirely unfamiliar set of rules when it comes to your taxes.
Whether you are considering becoming a franchisee or already involved, it’s essential to have the support of a knowledgeable tax planner. This will help ensure you understand your tax obligations and are preparing accordingly. Here are just a few of the things that you need to keep in mind:
Franchisees Pay Self-Employment Taxes
The franchise gives you direction on marketing materials, training methods, employee rules, and suppliers. However, you are still in charge of the business in ways that the IRS defines as self-employed. For example, you make your schedule and establish your own community and business relationships, so the government puts you in the same category as a sole proprietor. This means you need to report your earnings on a Schedule C like single-member LLCs and sole proprietors. In addition, you would need to pay the additional 15.3% tax that self-employed people are assessed.
Though this may feel excessive, if you were an employee, the employer 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. 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 integral part of your financial planning that an experienced tax professional can ensure you have prepared for properly.
Are You an Active or Passive Participant?
One of the advantages of being a franchisee is being either an active or passive participant. Deciding 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. Therefore, establishing whether your earnings are passive or active will be one of the first tasks on your tax professional’s list. They will do this by asking focused questions so they can precisely learn 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, that rule will still apply.
Over 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?
Suppose you worked at least 100 hours on the business and no less than anybody else. In that case, you can be considered an active participant.
These are just a few of the IRS’s material participation tests, and it’s an essential determination because of how passive losses are handled. For example, suppose you have been identified as passively involved. In that case, 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 compensate them. You would never be able to deduct passive losses against wages, active business earnings, or other ordinary income.
The Benefits of Investing in Your Franchise
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 the tax year 2022. After, the bonus depreciation level will drop 20% each year, lowering to 80% in 2023, 60% in 2024, until it is completely gone at the end of 2026.
Suppose you are purchasing a business structure rather than leasing one. In that case, 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 improvement property (QIP) to be deducted over a shorter recovery period as long as their costs are separate from the cost of the building itself. Having a cost segregation study to support this depreciation can make a significant difference in your tax liability.
Be Aware of Specialized Tax Incentives You May be Eligible For
Different types of businesses are eligible for specialized tax incentives. 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. This allows you to claim the difference between the taxes you pay on your workers’ tips and the Federal minimum wage.
Opportunity Zones – The sale of a property is generally a 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 explicitly identified to promote investment. Suppose your franchisor permits you to open a franchise in a qualifying area. In that case, you will be rewarded by a deferral of capital gains liability. Or, if you keep the property and business there long term, you can potentially eliminate the capital gains liability.
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. The amount of the credit depends on numerous factors, including the specific targeted group and the employee’s tenure with your organization.
Why Franchisees Need Expert Tax Help
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.