When the U.S. Congress enacted the Tax Cuts and Jobs Act of 2017, the legislation made some major changes to the tax code. Let’s talk about a few that directly affect the franchising industry.
The law created a new deduction for qualified business income. Formally referred to as the Section 199A deduction, this is called the passthrough deduction — it means taxpayers can deduct 20 percent of qualified business income on their personal tax returns. For example, if your business generated $100,000 in net income, only $80,000 would be subject to personal income tax. The law does limit deductions above a $157,500 single/$315,000 marriage taxable income threshold for certain types of franchise businesses.
If your franchise is a professional services business, such as accounting or bookkeeping, there is an income cap. If you hit the $157,500 single/$315,000 marriage taxable income threshold, you are not eligible for the deduction. But for other franchises, such as restaurants or retail or automotive services, the income limit does not apply.
Another big effect of the law is related to asset expensing and depreciation. Under the old tax laws, when you bought a new asset you could depreciate half of it as a bonus deprecation, or you could write off 100 percent of it over a number of years under Section 179. Under new tax laws, through 2022, any new or used piece of equipment that your business purchases, you can deduct 100 percent of the example as bonus depreciation.
When you buy any new equipment for your facilities — for example, you put in brand new windows around a restaurant or purchase a new lift for a car maintenance franchise — you can deduct 100 percent of all those expenses instead of having to depreciate it over its useful life.
A note of caution: Some states have elected to not allow bonus deprecation. Be careful to look at the state side of the tax equation when you are depreciating something. There could be a hidden tax because the state has decoupled from federal asset depreciation regulations.
The next topic is something that might sound small but can have a very big effect on both franchisors and franchisees. The new law gutted the ability of businesses to deduct meals and entertainment (M&E) expenses.
Previously, business owners were able to deduct 50 percent of the cost of all meals and entertainment. If the employer was providing the meals to the employee, they could deduct 100 percent. That was changed. Entertainment expenses can’t be deducted at all.
This could very well be one of the biggest pitfalls for franchises. If franchise owners have to attend a lot of franchise brand meetings and conferences, they are not going to be able to deduct as much of the expenses of those trips as they used to.
Franchisors will have to look very carefully at how they structure conferences. If they choose to fund costs for programming and lodging, they’ll have to treat it as taxable income for attendees, issuing 1099 forms to report the income.
Want to give away football tickets to show appreciation for star employees? Get a 1099 ready for them, because that’s no longer a tax-deductible expense. Are you in franchise development and working hard to win a free trip to Aruba for generating leads for your network? If it’s not properly classified, you could have to pay tax on that entire free trip you earned.
Balancing the Books
This last change can benefit the individual franchise owners. It involves allowable accounting methods for taxing purposes.
Franchisors often require individual franchise owners to report everything under the accrual basis of accounting, in order to make it easier to calculate royalties over all their revenue; however, the IRS has issued guidance that gives those franchise owners more flexibility in the accounting method they use to calculate income for federal taxes.
If you’re a franchisee with under $25 million in annual revenue, you can opt out of accrual basis accounting for your federal taxes and go to a cash basis of accounting. They would have to keep one set of books to meet franchisor requirements, but could maintain another set of bookkeeping records under the cash basis of accounting for calculating their income taxes. Those two accounting methods can be used hand in hand while saving significant dollars.
Summing It Up
These are not the only changes made to the tax code by the Tax Cuts and Jobs Act of 2017. The full effects of the complicated law won’t be known for years. Don’t try to navigate the changes alone. Be sure to reach out to licensed tax and accounting experts to help find new opportunities in the tax code while avoiding harmful pitfalls.
Tab Burkhalter is the managing partner of The Burkhalter Group, which is composed of a regional law firm (Burkhalter & Burkhalter), regional CPA firm (Burkhalter & Associates), business start-up and back-office service provider (Numbers House) and commercial real estate lessor.