Tax planning to help new franchisees

February 2022

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 adviser 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.

Organising your franchise

How you organise your franchise is going to be one of your earliest decisions, and one of your most important. From a tax perspective, your tax adviser can advise on different incorporated and unincorporated structures and the tax implications of each. You should also be sure to engage an experienced franchise lawyer to review legal documents related to the franchise, lease agreements, and/or bank loans. The lawyer 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, suppliers, and many other decisions, you are still in charge of the business in ways that the tax authorities may define 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. This means you need to report your earnings as a self-employed person. In the US this means on a Schedule C, just like single member limited liability companies and sole proprietors do, while paying the additional 15.3% tax that self-employed people in the US are assessed. 

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 can have important tax ramifications. Establishing whether your earnings are passive or active will be one of the first tasks on your tax adviser’s list. By answering questions like the ones below, your adviser 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 and regularly participated in the business can be determined to be active participants, regardless of their answers to any other test questions they might be asked.

• Over the course of the past year, how many hours did you actively participate in the business?

While treatment in various jurisdictions will vary, in the US, if you answer 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 spend similar hours working in the business to others, it is easy to see you are an active participant. In the US, if you work at least 100 hours on the business and no less than anybody else, then you can be considered an active participant.

These are just some methods a tax authority might use to establish your active participation in the business. It can be an important distinction as it may affect the way that passive losses are handled. If you are identified as passively involved, then any losses you realise as a franchisee may only be offset by other passive income, so you might be unable to offset passive losses against wages, active business earnings, or other ordinary income.

Any passive loss rules will likely apply whether you decide to incorporate your franchise, operate as a partnership, or as a self-employed individual.

Be aware of eligibility for specialised tax incentives

Different types of businesses may be eligible for specialised local tax incentives, and if you are new to franchising you may not be fully aware of them. Your tax adviser can help identify them for you, but here are some examples of incentives that exist in the US:

• 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 a 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-offenders, food-stamp recipients, and others; the amount of the credit is dependent on numerous factors, including the specific targeted group and the employee’s tenure with an organisation.

Why franchisees need expert tax advisers

The opportunities that come with being a franchisee can bring 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, you should seek professional and expert help and advice.

About the author

Karen Snodgrass
Chicago, USA

Karen is a principal at Russell Bedford’s Chicago member firm Cray, Kaiser Ltd. She oversees CK’s tax division, with niche expertise in closely held and family owned businesses. In her tax planning work, she minimises liability at the entity and individual level by helping clients think through the tax implications of their decisions throughout the year. Having successfully navigated evolving tax codes for more than 20 years, Karen leads seminars on tax law updates at the firm.

Author: Karen Snodgrass - Cray, Kaiser Ltd., Chicago, USA

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