Tax Planning to Help New Franchisees

Your investment can be a wonderful opportunity, but it also involves a completely unfamiliar set of rules when it comes to your taxes. Whether you are considering becoming a franchisee or are already involved, it’s important that you have the support of a knowledgeable tax planner to help ensure you understand your tax obligations and are preparing accordingly. Here are just a few of the things that you need to keep in mind:

Franchisees Pay Self-Employment Taxes

Even though you take direction from the franchise on marketing materials, training methods, employee rules, and suppliers, you still are in charge of the business in ways that the IRS defines 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. That means you need to report your earnings on a Schedule C, just like single-member LLCs and sole proprietors do, and you need to pay the additional 15.3% tax that self-employed people are assessed.

Though this may feel excessive, if you were somebody’s employee, they would be taking out payroll taxes on your behalf to cover Social Security and Medicare for your future. That is what the additional taxation is for. Unfortunately, as a franchisee, you will have to pay that amount regardless of whether your income ended up in your pocket as take-home pay. Just as is the case for participants in a partnership, it doesn’t matter whether profits are reinvested in the organization or paid out as distributions. They still count as self-employment income and are taxed as such. Keeping this liability in mind is an important part of your financial planning that an experienced tax professional can ensure you have prepared for properly.

Are You an Active or Passive Participant?

One of the advantages of being a franchisee is that you can be either an active or passive participant. Making the decision about whether you are hands-on or simply purchasing the business and handing off day-to-day operational responsibilities to a partner has important tax ramifications. Establishing whether your earnings are passive or active will be one of the first tasks on your tax professional’s list, and they will do this by asking questions like the ones below, which are geared to learning exactly 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 participated in the business in five of the previous ten years can be determined to be active participants, regardless of their answers to the other test questions they will be asked.
• Over the course of the past year, how many years did you actively participate in the business? If your answer is more than 500 hours, the IRS can consider you a material participant rather than a passive one.

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