PFIFA Maximizing After Tax Cash Flow Under the New Tax

Planet Fitness Franchises: Maximizing After-Tax Cash Flow

Entrepreneurs are always thinking about how to maximize their cash flows and their growth, which is even more intriguing given the new tax law.

For example, under a new provision of the tax law, owners of pass-through entities can deduct 20 percent against their taxable income. While the calculation can be a little tricky, most franchisees are positioned to permanently reduce their top marginal tax rate from 37 percent to 29.6 percent.

There is a warning, however. The new tax law fast-tracks future deductions into the present. This includes 100 percent depreciation of new and used qualified equipment, as well as qualified leasehold and real property improvements. This looks very tempting, so tempting, in fact, that it might cause the unsuspecting franchisee to overextend the use of these deductions, which will ravage other deductions and graduated tax rates. This misuse of these shelters should be avoided, and instead, the shelters should be strategically spread out over many years with the objective of reaching a constant, year-over-year federal tax rate equal to the capital gains tax rate of 20 percent.

While on the surface these deductions sound like a great way to immediately lower the 29.6 percent tax rate even further, I would caution franchisees to proceed carefully and make sure this rush forward with first-year deductions doesn’t create more net taxes later on. Consider for a moment, the economic life of the assets acquired by a Planet Fitness® franchise entity. That economic life ranges anywhere from five to seven years because of contractual commitments with the franchisor, so by default, this becomes the period of time that the cumulation of the earnings process occurs on those assets. If the full deduction on those purchased assets is taken in year one, franchisees could zero out their current year federal income taxes and be exposing themselves to a higher tax rate in years two through seven, thus reducing or inadvertently eliminating the full value of these strategic tax assets.

An unfortunate result of tax reform is that state income taxes can no longer be federally deducted, other than $10,000. This can take a real bite out of after-tax cash flow, and it sets up a scenario where it’s more favorable to be in certain states than in other states. All is not lost though as there are ways to avoid those taxes even though you are in a high-income tax state. One such way is through residency or through the use of certain types of trusts. For example, if you have a trust and it’s domiciled in certain select states, then any LLC units that are held by that trust would be deemed, in effect, the property of that state. It’s important to note that there are 10 states (New York, for example) that do not recognize non-resident trusts, but there are many more that do, so you’ll need to do your homework first.

This strategy isn’t for everyone because there’s complexity involved, and one needs to look at the cost/benefit analysis of it. Quantitative factors such as passive investment taxes, sourced trade or business income/real estate, and administrative fees to set up and manage the trust need to be weighed along with other qualitative factors, but if it’s determined that it makes sense to go forward, then this gateway into another tax haven is definitely worth a look. Bottom line: These types of trusts may not be applicable today but could be applicable at some point down the road. In addition to resolving part of the state income tax issue, if a franchisee is really interested in developing wealth beyond their own life, then these trusts can create dynasties that only few Americans have ever accomplished.

Irrespective of the changes present in the new tax law, I want to point out the Work Opportunity Tax Credit. This has been around for some time yet continues to be a relatively unknown/ unused tax saving opportunity. The WOTC is a federal tax credit available to employers who hire and retain veterans and other individuals with significant barriers to employment. Planet Fitness franchisees can save 40 cents on eligible payroll dollars related to a qualified hire, up to the first $6,000 in many instances (and up to the first $9,000 in other cases). High employee turnover rates are typical in this type of business, thus making Planet Fitness franchisees near perfect candidates for the WOTC. And the ironic thing is that the franchisee doesn’t need to do anything more than what they’re already doing to take advantage of this tax opportunity – the work is actually done by their payroll service provider or another third party. The franchisee doesn’t have to pay any money to administer it as the payroll service provider will take a piece of the action if there is any action to be had.

Another tax opportunity that has largely been overlooked by many within the Planet Fitness network is a 1031 tax-free exchange. The majority of Planet Fitness franchisees lease their property. If they were to have lease terms with renewal options that extend to 30 years, the value of those leases and improvements at the day of transaction, if a transaction were to occur, would actually have a favorable tax retreatment as the franchisee could roll that money over as a 1031 tax-free exchange, just like it was real estate.

As a final takeaway, to progress forward the objectives of Planet Fitness entrepreneurs, I strongly advise you to evaluate the long-term impact of the tax bill in consultation with their strategic tax advisors. The tax code and its associated regulations are comprised of over 10 million words, so it’s essential you seek out those who know and understand its complexity in order to raise your own awareness as a business operator and put visibility on what otherwise may be hiding in plain sight.

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This article originally appeared in Geared Up’s 2018 Issue 1, published by Planet Fitness Independent Franchisee Association.

Carl Famiglietti
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