Tax planning for franchises: Four considerations to maximize your tax benefits post-tax reform
State and local tax
When most franchises start out, their corporate presence is restricted to a single location or state. But as the business grows, it may expand both within the state and in other jurisdictions. Expansion can take the form of physical stores or locations where products or services are sold to the public, or it may involve sending salespeople to a neighboring state to solicit new franchisees.
If your business is expanding, your state and local tax exposure and liabilities may change — in some cases, dramatically and unexpectedly.
In either case, if your business is expanding, your state and local tax (SALT) exposure and liabilities may change — in some cases, dramatically and unexpectedly. Even without a physical presence (office) in a neighboring state, a sales team’s activities there may create a taxable presence. In certain instances, you may find that you are taxed in excess of 100 percent of profits, clearly an undesirable consequence and one that can (and should) factor into your growth strategy.
The first step to assessing tax liability is determining nexus. Nexus is what a state considers to be a taxable presence within that state. For a franchisee opening a store or restaurant in a state, nexus is clear, and state tax liability is well understood. However, take the case of a franchisor whose sole corporate office is in its home state. Other states may rule that nexus is established for that franchisor as long as it has franchisees located in that state.
A multistate business may, therefore, unknowingly be exposed to tax liability with substantial tax consequences. Furthermore, the countdown for the statute of limitations will not begin for a taxpayer that has established nexus, but failed to file a tax return. In other words, the state has the right to reach back for all years in which a state filing was not made. In such instances, a voluntary disclosure agreement (VDA) may be available to allow the taxpayer to remit past-due taxes without penalty.
Analysis of apportionment rules in a multistate environment can result in tax consequences that are favorable to a taxpayer. Differing state requirements sometimes result in situations where less than 100 percent of activity is taxed at the state level.
Sales and use taxes
The sales tax environment has been significantly altered with the Supreme Court decision in the Wayfair case in June 2018. A review of new sales and use tax requirements as a result of Wayfair can identify exposures that didn’t exist prior to 2018 and mitigate them through the VDA process.
Any franchisor or franchisee considering or taking part in multistate activity should review its operations to assess its tax exposure and potential liability while exploring opportunities for “nowhere” apportionment. With varying rules for nexus and apportionment in each state, it’s essential to understand the distinctions and build a growth strategy accordingly.
There are a number of tax credits available to franchisees that are often overlooked. Two of the most important are the work opportunity tax credit (WOTC) and the FICA tip credit, which is pertinent to restaurant franchises.
There are a number of tax credits available to franchisees that are often overlooked.
WOTC reduces income taxes for companies that hire employees from certain targeted groups, such as financial aid recipients, qualified veterans, qualified ex-felons, or the disabled. Generally, WOTC is calculated based on wages that cover services rendered during the one-year period starting on the day the employee begins work. The credit is valid for qualified individuals who begin work on or before Dec. 31, 2019. After Jan. 1, 2020, this credit expires, so businesses are encouraged to take advantage of it while they can.
Businesses that employ workers who earn tips can claim a credit against their federal income tax based on the share of FICA and Medicare taxes they pay on employees’ reported tip income. The calculation is a bit more complicated than simply multiplying reported tips by the FICA percentage. Taxes are reduced based on what are known as “creditable tips.” The FICA tip credit is included on the General Business Tax Credit (GBTC) portion of the employer’s tax return. Because it’s not a refundable credit, it can’t reduce a tax liability below $0. However, any unused portion of the credit can be carried forward and applied to future tax returns.
Many new businesses choose cash basis accounting rather than accrual basis. The former is generally easier to track and understand since the company pays tax on income when it’s received. The cash basis method is tied to cash flow without regard to accounts receivable and accounts payable.
As a company grows, the accrual basis offers a more precise view of long-term financial health. It may also offer appealing tax advantages, allowing it to defer tax obligations. In prior years, the IRS required many companies to be on accrual method due to restrictive eligibility; however, the Tax Cuts and Jobs Act has raised the threshold. Businesses may now use the cash method of accounting if they have average gross receipts of $25 million or less in the three prior tax years.
Timing is critical when making an accounting method change: You must be able to anticipate when you’ll reach the income threshold governing accrual accounting. Even if you fall short of that income level, recognizing what deferral opportunities exist, and being able to successfully convert methodologies, will minimize your tax liabilities.
Building costs and improvements are a significant component of many franchise businesses. For tax purposes, these costs are generally depreciated over a lengthy 39-year period. However, franchisees can realize the tax benefits of more rapid depreciation by undertaking a cost segregation study. Cost segregation identifies personal property that can be depreciated over a variety of shorter recovery periods utilizing accelerated depreciation.
Franchisees can realize the tax benefits of more rapid building cost depreciation by undertaking a cost segregation study.
Improvements to a facility that are not necessary for general building use often have shorter depreciation lives. These might include portions of plumbing, electrical wiring, mechanical systems, finishes such as carpeting or flooring, and certain types of equipment. Land improvements may also qualify, including such items as parking lots, sidewalks, light poles, and storm sewers.
For example, if a franchisee builds out space in an existing building with a construction spend of $1 million, a cost segregation study will result in approximately $100,000 in first-year savings, assuming a 6 percent discount rate and a 40 percent combined federal and state tax rate.
A cost segregation study can be performed during the year a franchise is being constructed or remodeled. This allows the franchisee or franchisor to immediately optimize tax savings and accurately classify assets. But post-construction is not too late: IRS Form 3115, Application for Change in Accounting Method, makes it easy to go back and claim missed depreciation on assets acquired as far back as 1987 without amending prior tax returns.
If you haven’t updated your tax-planning strategy since the new tax laws passed, you’re leaving money on the table. Consider how much you’ve grown since the last time you updated your strategy, factor in the numerous tax credits available to franchises that you may not have been aware of, and you might find there’s a hefty chunk of change you could be reinvesting in your business. Give us a call and make sure you’re maximizing your tax benefits — your stakeholders will thank you for it.