Recently in Tax Category

If you are selling your franchise, then you probably are subject to capital gains taxes. As a general rule, the sale of property subjects the seller to capital gains taxes.

However, exception to this general rule may apply if you are using the money to purchase another franchise business, if the sale applies for a "1031 exchange" you may be able defer losses or gains if you purchase like-kind property within a specified period of time after the sale.

The details are complicated and here is a general overview.

First, the 1031 exchange definition is complicated; however, the Internal Revenue Service Code states, in relevant part, that "no gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged solely for property of a like kind to be held either for productive use in a trade or business or for investment".

The definition of "like-kind" property is crucial to a determination of whether a transaction qualifies. Certain kinds of property are specifically excluded from qualifying for a 1031 exchange.

According to the IRS Code, the following types of property are disqualified:

(i) Stock in trade or other property held primarily for sale;

(ii) Stocks, bonds, or notes;

(iii) Other securities or evidences of indebtedness or interest;

(iv) Interests in a partnership;

(v) Certificates of trust or beneficial interests; or

(vi) Choses in action.

In order to better understand how a 1031 exchange works, consider the following example. Imagine that you own a rental property in Indiana that was originally purchased for $50,000. Since the purchase, you have completed $20,000 worth of improvements on the property, however, the property has also depreciated by $10,000.

Imagine further that you now wish to sell the property. The sale of the property grosses $145,000 with selling expenses of $10,000. The profit from the sale of the rental property would normally be subject to capital gains taxes totaling $14,800 if you are in the 25 percent, or higher, tax bracket. If, however, the sale qualifies for a 1031 exchange, you will be able to hold onto the $14,800 that you would have paid in capital gains taxes, interest free, until such time as you sell the replacement property.

(At 3.5 percent interest, that reflects a savings of $518 per year, or $2,590 over a five year period of time. Of course, if the $14,800 you held onto as a result of using a 1031 exchange is investment in a higher yielding investment, your savings will increase accordingly.)

The replacement property must be one of like-kind. In the above example, this means you cannot purchase a property in which you plan to live to replace a rental property. In addition, the replacement property must be purchased within 180 days after the sale of the original property to meet the 1031 exchange definition.

This has been a guest post by Andy Gustafson. Since 2003, Andy has been a qualified intermediary of Internal Revenue Section 1031 tax deferred exchanges earning the Certified Exchange Specialist(r) designation. Individuals and companies, both domestic and foreign defer federal and state capital gains and recaptured depreciation taxes when selling and replacing real and personal property held for investment or in a business. This postpones and in some scenarios eliminates tax payment.

Earlier this year, we reported that in KFC Corporation vs. Iowa Department of Revenue, the Iowa Supreme Court upheld the state's ability to assess income tax on KFC Corporation and other out-of-state franchisors who, despite not having a physical presence in Iowa, nonetheless derive revenue through its franchisees. The Iowa Supreme Court held that a franchisor's physical presence in Iowa is not a required element in determining whether a sufficient tax nexus exists to justify the imposition and collection of state income tax.

Recently, the United States Supreme Court declined to review the Iowa Supreme Court's ruling with respect to physical presence and substantial tax nexus. The implications of the Supreme Court's declining to review the KFC nexus case are potentially far reaching in that other states, including Iowa, will now begin to aggressively pursue the collection of income tax from out-of-state franchisors who have no physical presence in a state. The tax nexus ruling could also affect other areas of interstate commerce where there is no physical presence.

We expect that states will begin adopting their own tax nexus analysis based loosely on the Iowa Supreme Court's analysis and will soon require out-of-state franchisors to begin filing income tax returns if they are not already doing so.

Franchisors with significant presence in multiple states should begin preparing for what seems to be an inevitable outcome with respect to reporting and paying state income tax in each state they will be deemed to have a sufficient tax nexus.

Franchisors may consider spreading the cost of additional tax among their franchisees through higher fees or higher cost of goods. This could result in the consumer's paying a higher price for the franchisor's good or service.

If required to file and pay state income taxes, franchisors who previously were not subject to state income tax need to begin analyzing their taxable income with respect to those states in which they derive franchise income not only to determine their potential state income tax liability, but also to begin planning with respect to reporting and accounting procedures.

Franchisors should conduct tax planning and analysis at the state level where they will now be required to report and pay income tax, but the analysis should start at the federal level with respect to income, expense, deduction and planning opportunities to minimize tax exposure at the state level. As part of the analysis, franchisors may want to examine their current franchise structures to determine whether income and deduction items are properly characterized.

This has been a guest post by Tae Shin, Associate with Roetzel & Andress. For help in tax planning for out-of-state franchisors, please contact attorney Tae Shin in Roetzel’s Franchise Law group.