What Taxes Apply When Selling a Franchise? What Owners Need to Know

What taxes apply when selling a franchise? That depends on the structure of the sale, the assets involved and the seller's individual tax situation. Even when the sale price looks good on paper, the amount an owner actually takes home can be considerably less if taxes haven't been factored into the deal.

Zachary Sahar, a CPA and managing director at Capital Tax, has spent more than 20 years advising business owners on tax issues. In his experience, sellers don’t always have a complete picture of the financial consequences of a transaction.

“Many sellers focus on the sale price but underestimate the tax bill,” Sahar said.

The Taxes Franchise Sellers Should Expect

A franchise sale can trigger more than one type of tax, and the amount owed depends partly on which assets are included in the sale. Different portions of the proceeds may receive different tax treatment, making it important for sellers to understand their potential obligations before agreeing to a deal.

“Depending on how the transaction is structured, owners may face federal capital gains tax, depreciation recapture that is taxed at ordinary income rates, state income taxes and potentially the net investment income tax,” Sahar said.

A seller might have taken depreciation deductions on equipment for years without thinking much about what happens when it's time to sell. Those earlier deductions can affect the tax bill, since some of the gain may be treated as ordinary income. The equipment's adjusted tax basis and the rules governing the transaction determine how that gain is taxed.

How Purchase Price Allocation Changes the Tax Bill

A sale agreement doesn't simply assign one price to the entire business. It may allocate the purchase price among equipment, inventory, goodwill and other assets, and those allocations can affect how the seller is taxed.

“Purchase price allocation is one of the most important tax negotiations in a business sale, yet it’s often treated as an afterthought,” Sahar said.

The allocation deserves attention before the agreement is finalized. The tax treatment of equipment can differ from that of goodwill and other intangible assets, and prior depreciation deductions may affect the gain recognized on equipment. The seller's entity structure and the terms of the deal also matter. Once the buyer and seller have agreed on the allocation, changing it may be difficult.

State Taxes Can Shrink Net Proceeds

The seller's state tax bill can be another source of uncertainty, particularly for owners with locations in more than one state.

An owner's tax obligations may depend on where the owner lives, how the business is structured and where the business income is sourced. Multi-unit operators may need to account for filing obligations in several states. Reviewing those issues early can help sellers avoid an unexpected bill after the transaction closes.

The Most Common Tax Mistake Sellers Make

The timing of tax planning can have a significant impact on how much a franchise owner ultimately keeps from a sale. For that reason, sellers need to consider the tax implications alongside the other financial terms of a potential transaction.

“The biggest mistake is bringing in the CPA after the deal has already been negotiated,” Sahar said. “By that point, many of the decisions that drive the tax outcome have already been made.”

Bringing a CPA into the process before negotiations begin gives the seller a chance to review the proposed structure, understand the likely tax consequences and raise issues before the terms are settled.

Key Takeaways: How to Prepare Before Listing a Franchise for Sale

Sahar encourages franchise owners to get their financial information in order well before putting the business on the market. That includes reviewing the tax basis of their assets, taking another look at how the business is structured and making sure their records are organized. A CPA can then run through different sale scenarios to estimate what the owner might owe in taxes.

Before listing your franchise for sale, start with these two steps:

• Consult a CPA early. Review the likely tax consequences and identify issues that could affect the deal before negotiations begin.
• Review the purchase price allocation. Understand how the amounts assigned to equipment, goodwill and other assets could affect your tax liability before agreeing to the final terms.

This article is for informational purposes only and does not constitute tax or legal advice. Franchise owners should consult a qualified tax professional about their specific situation.