Tax-efficient structuring for franchise businesses
When organizing a new business, many franchise owners go through an in-depth process of trying to design a structure that will provide the best potential benefits for their venture. Often they’ll assemble a team — including an attorney, accountant, and other valued advisors and mentors — to take them through the process. Once the team is in place, it’s time to consider a host of important factors, from cost of formation to legal liability to succession and exit planning. This article affords a brief overview of these and other factors important in determining a tax-efficient structure for a franchise business.
There are a variety of strategic issues to consider that will arise at different points of an organization’s life cycle. Among the most important are:
- Legal liability.
How much of their net worth outside of the business do owners want to expose to company creditors?
- Cost of formation and ongoing administration.
How expensive is it to set up the business, and what types of capital can be expected to keep the entity in good standing?
- Flexibility of ownership.
How many owners are there? Will there be full equity ownership or limitations? What is the capital structure, and how will equity or debt be used?
- Succession and exit planning.
What happens if an owner dies or is incapacitated? How will the succession of key employees or family members be addressed? This is one of the more difficult considerations to address because it’s difficult to wrap your mind around the endgame at the beginning stages of a company. Still, these questions must be addressed.
But perhaps the consideration that weighs most heavily on business owners’ minds is tax implications. While those factors listed above (and others) may wax and wane through a business’s life cycle, tax considerations are consistently of high importance.
Our role as tax consulting professionals is to look for opportunities to minimize tax and identify and assess risks, all in an effort to assist in managing a company’s capital for operations and growth. The goal is to consider both short- and long-term issues, including:
- How can income taxes on the profits of the business be minimized, deferred, or both?
- How can tax losses incurred in the business enterprise be used advantageously? In particular, can these losses offset other income, including possibly the business owners’ income?
- How can increases in the value of the equity of the business best be protected from future income and estate tax liabilities?
- How can assets be transferred into and out of the entity in the most tax-efficient manner?
- Do special tax rules, such as the at-risk provisions and the Alternative Minimum Tax regime, apply differently to certain types of entities or certain activities of an enterprise so as to encourage the use of one entity form rather than another?
The answers to these tax questions, in part, are dependent upon the taxpayer’s entity structure. Additionally, the taxpayer’s operational, financial, and managerial strategy will significantly influence how the planner arrives at options for tax-efficient recommendations and improvements.
Factoring in change
Most companies don’t remain constant. In fact, change is the one thing that we can depend upon in business, as in life. Additionally, tax rules change often — at least annually.
Quite often, an external influence or internal decision may cause a very real need to reconsider the planning around the tax structure of the business enterprise. There are a variety of changes and influences that can cause a need for reevaluation, including:
- A change in profitability or a new source of revenue (new product or service).
- Operations in a new or different geography.
- Regulatory changes.
- Management and ownership adjustments.
- A change in capital needs or structure.
- A change in an owner’s succession plan.
Once the change has been identified, the planner must now consider whether there are opportunities to react and offer ideas to once again improve the tax efficiency.
A client example: The challenge
Here’s a recent example from our client base where external and internal factors arose that required a need to strategically restructure the company.
This particular client formed a limited liability company (LLC) to house operations of a retail concept that contemplated opening multiple units in a single state. Originally, the company was formed and funded by two family groups. Post-formation, the company began to execute its operational strategy. The strategy proved successful, and the company began to grow. Sometime thereafter, an opportunity arose to acquire the operations of two geographically distinct businesses.
Because of these new opportunities, the company now needed a more significant financial partner to assist in taking advantage of the growth opportunities and to continue to fund operations in the existing business. Additionally, this new financial partner would also require equity in the companies as part of its participation. The company’s advisory team at the time suggested that acquiring the two new operations in separate LLCs was the smart choice. So they did.
The new multi-entity company began to operate and, after a couple years, significant tax problems arose, causing the owners great concern. The first issue related to the timing of deducting certain tax losses that were being generated in the two new entities from significant tax depreciation. The problem had surfaced because the owners lacked direction in how the losses should be funded in order to take advantage of the tax benefits being generated. In other words, the losses were currently required to be suspended in two of the three entities, while the third was actually generating taxable income. Unfortunately, certain specific at-risk provisions hadn’t been considered, so current deduction of the losses wasn’t possible.
The second significant issue was that the company was paying quite a bit in state and local income taxes. The problem was that no one had considered the potential benefits of combining the income of all entities as a tool for managing the various state tax liabilities. Additionally, high, ongoing administrative tax-compliance costs and uneven ownership between the entities left the owners very frustrated.
A client example: The solution
First, we gathered the company’s owners and the advisory team to thoroughly discuss the issues and current operational and financial strategies. Once we understood these goals, we were able to work toward designing an appropriate solution.
The solution comprised several pieces. First, we set up a new LLC holding company. As part of this step, the interests of the three prior LLCs were contributed to the new holding company in exchange for interests in the new holding company. Adjustments were made to the new LLC to provide for different classes of ownership, and improvements and clarity were penned into the exit opportunities for the members. Effectively, each of the old LLCs became 100 percent owned subsidiaries of the new holding company.
Second, a management company was formed (an S corporation) as the new manager of the holding company. The tax benefits of this planning were:
- A better use of the combined basis of the entities, which allowed current loss utilization from any of the subsidiaries or parent. Additionally, the previously suspended losses became immediately usable.
- The combined reporting of income provided the opportunity to minimize state and local taxes to the company.
- By using a management company, we were able to minimize self-employment taxation and provide the owners with federal and state withholding opportunities.
- We reduced tax compliance costs to the client.
- We provided opportunities to simplify the state and local tax reporting for the owners.
The non-tax benefits were equally as significant and include simplified financial reporting, clarified ownership of the entire entity, simplified exit strategies, and more flexibility in compensating managers and owners.
There are a variety of factors franchise owners must consider when embarking on a business venture. Tax considerations are at the top of the list. For more information on how to minimize taxes and best structure a franchise business, contact your tax advisor.