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Use Tax Planning Software to Help New Franchisees

Opening a franchise is exciting, but it can also be stressful, especially when taxpayers try to go it alone. When your clients seek your help, they’ll want a partner who can help them navigate their new venture. Because franchisees have some unique tax requirements, it’s important that you’re prepared to help them on their journey. A good tax planning software will provide you with all the tools you need to help your clients feel confident that their business plans are on track.

Self-Employment Taxes

Franchisees have quite a bit of control over how they run their business; they can hire their own employees, set their own schedule, and build relationships with other businesses in the community. But signing onto a franchise also requires them to give up some freedoms; the franchisor will be the one approving suppliers, creating marketing materials, and establishing training methods.

This loss of freedom is why some people believe that franchisees are not self-employed. But franchisees, just like other business owners, may owe self-employment taxes on their earnings. It’s not their freedoms that determine whether they are self-employed – it’s their taxing entity.

Sole proprietors and single-member LLCs who report business earnings on Schedule Cs will owe self-employment taxes on their net earnings. Partners in a partnership are also considered self-employed and must pay self-employment tax on their distributive share of the partnership’s earnings (this includes owners of multi-member LLCs that are taxed as partnerships). Only corporations, S corporations, and LLCs that elect to be taxed as corporations will not be subject to self-employment taxes.

Self-employment taxes are an additional tax of 15.3% on self-employed earnings. This tax mirrors payroll taxes that employees and their employers pay on wages and salaries. Self-employment taxes are the IRS’s way to ensure self-employed persons pay into Social Security and Medicare.

Your clients will owe self-employment tax on all self-employed earnings regardless of how much cash they take home. For example, partners in a partnership will report their entire distributive share of partnership earnings as self-employed income whether those earnings were paid out in a distribution or reinvested into the business. Prepare your clients by adding this additional liability into their tax projection. If you have a good tax planning software, you can project this liability out over several years. Your clients can use this information to ensure they take enough cash out of the business to cover their tax liability.

Passive Activity Losses

Ask your client how active they are in their franchise. If your client provided the capital to purchase the business but lets their business partner manage the day-to-day operations, their earnings from that franchise will likely be classified as passive.

To know if they materially participate in their business, you’ll need to ask them some of the following questions:

  • How many hours did you participate in the business during the year? Taxpayers who work at least 500 hours on the activity are deemed to have materially participated in the business.
  • What is your participation level compared to others in the business? Your client may be considered active in a business if they worked at least 100 hours and worked no less than any other individual.
  • How long have you had this business? If your client has had this business and materially participated in five of the past ten years, they may be considered an active participant in the business even if they did not pass one of the other participation tests in the current year.

Familiarize yourself with all seven of the IRS’s material participation tests.

Knowing whether your client’s activity is active or passive is important because passive activities are treated differently for tax purposes than other activities. Losses from passive activities can only offset losses from other passive activities. If your client reports a passive loss from their franchised business and has no other passive income to offset, they can carry those suspended losses forward, but they cannot deduct that loss against ordinary income like wages or other [active] business earnings.

New Capital Expenditures

The tax code looks kindly on taxpayers who invest capital into their businesses. Capital expenditures, like new equipment and furniture, may be fully deductible in the year of purchase. The Tax Cuts and Jobs Act (TCJA) which was passed at the end of 2017 extended 100% bonus depreciation through tax year 2022. Beginning in 2023, bonus depreciation drops to 80% and then reduces 20% each year until it expires in 2026.

Franchisees may also benefit from commissioning a cost segregation study. A cost segregation study is something that you or a specialized CPA can perform to segregate non-building components from the costs of a building. By separating these non-building components from the building itself, those expenditures can be deducted over a shorter recovery period. The Coronavirus Aid, Relief, and Economic Security (CARES) Act boosted this benefit further when it made qualified improvement property (QIP) eligible for bonus depreciation.

QIP are improvements made by the taxpayer to the interior portion of existing buildings. The CARES Act classified QIP as 15-year property under MACRS, which makes those costs eligible for bonus depreciation. If your client has QIP (e.g. drywall, ceilings, interior doors, electrical, etc.) that has been lumped in with the cost of their building, they can separate those costs out using a cost segregation study and potentially deduct those expenses immediately using bonus depreciation.

Tax Incentives

If your client owns a restaurant franchise or another business where tips are common, they may be eligible for the FICA tip credit. Your client can claim this credit for FICA taxes they pay on their employees’ tips that exceed the Federal minimum wage. This credit reduces their income tax liability.

Work Opportunity Tax Credit

If your client hires employees from groups that face barriers to employment (veterans, ex-felons, food stamp recipients, and others), they can claim a credit of up to $9,600 per new hire depending on the employee’s targeted group and how long they remain employed with your client’s business.

Opportunity Zones

Your clients can defer capital gains recognized from the sale of almost any property if they reinvest those gains into a qualified opportunity zone. The opportunity zone program encourages investment in economically depressed areas by allowing taxpayers to defer (and potentially even eliminate) capital gain for long-term investments. If the franchisor allows for it, your client may be able to open their franchised operation within an opportunity zone to take advantage of this incentive.

Use Tax Planning Software for CPAs to Help Franchisees

New franchisees want a business partner who can join in their enthusiasm but also someone who will tell them the truth, even when they don’t want to hear it. You can fill this role for them. Good quality tax planning software for CPAs can make you invaluable to new business owners because the reports you generate can help them make long-term plans.

Tax decisions should not be made looking just one or two years ahead; it makes more sense for you to show your clients their tax positions projected many years into the future. Our Corvee tax planning software does this with the click of a button. The simple and easy-to-read reports will show your client how they are positioned currently and how their tax position will support their business years down the road.

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