Opening your first franchise can feel a lot like hitting the jackpot. Not only do franchised businesses provide you with well-tested operating procedures and a reliable support system, but they actually allow for quite a bit of flexibility – perhaps more than you think. Depending on your franchise, you may be free to make decisions about employment, accounting software, tax entity formation, vendors, or even financing. As you begin to unravel these opportunities and make the business uniquely yours, take a moment to consider the following tax impacts of your decisions.
As a new franchise owner, you may be liable for self-employment taxes. Self-employment taxes are both the employee and the employer portions of Medicaid and Social Security taxes, which amount to 15.3% of your annual self-employed income. Self-employment taxes are levied against individuals who carry on a trade or business as a sole proprietor or an LLC, which means that your choice of taxing entity will have a strong impact in this area.
Passive Activity Losses
The IRS’s passive activity loss rules have a history of sneaking up on taxpayers. These rules limit the amount of passive losses you can deduct in a given year. If you are a monetary investor in your franchise and provide very little day-to-day support of the business, you may very well be subject to these rules. Your franchise losses could offset other passive income, like income from (or gains from the sale of) another passive activity, and they would be ineligible to offset active income like wages or independent contractor revenues. While the losses can be carried forward to use in future years when your franchise becomes more profitable, not being able to utilize these losses immediately may impact some of your business decisions about growth and expansion.
Net Investment Income Tax
The Net Investment Income Tax (NIIT) is an additional tax levied against certain high-earning business owners. It kicks in when individuals’ modified gross incomes exceed a certain dollar amount for the year (in 2018, the limits for individuals and married taxpayers were $200,000 and $250,000 respectively). The net investment income of these high-earners, which includes capital gains, interest, dividends, and passive income from a business investment, is taxed at an additional 3.8%. And unfortunately, franchise income may be considered “passive business investments.” This additional tax may not seem like much, but it can quickly eat into your revenues without proper planning.
Thanks to the Tax Cuts and Jobs Act (TCJA), franchisees investing capital into their business can take advantage of the expanded accelerated depreciation rules now at play. Bonus depreciation is at 100% through year 2022, and Section 179 expensing allows a deduction of up to $1 million on capital expenditures. With the help of a savvy tax accountant, a franchisee can take advantage of these laws to maximize their deductions. While it may not be smart to accelerate the depreciation on every single equipment purchase required to get your franchise off the ground, it is a useful planning tool to consider.
Both Federal and state governments provide generous tax credits to their residents. The FICA Tip Credit is a great example. It is available to restaurants whose employees receive tips, provided they record and remit the appropriate information. The Work Opportunity Tax Credit is another great one to consider; it is a credit calculated as a percentage of the payroll paid to groups of individuals who face significant barriers to employment, including ex-felons, veterans and food stamp recipients. Many states will offer incentives to bring new businesses to their town, so talk to a professional well-versed in your jurisdiction to see what options are available to you.
Opening a new franchise is such an exciting business opportunity, and we want to see your business grow into the success you dream it will be. Considering these tax points can give you insight into this new world you’re about to enter and can ultimately help you reach your goals. If you have questions about how your new business opportunity will affect your taxes, contact your Spire Group professionals – we’re here to help.