Tax Aspects of Franchise Ownership

There are many advantages to purchasing the rights to own and operate a franchised business. 

Because the franchisor has already invested much of the effort associated with propelling a new business idea from concept to reality, the franchisee gets access on day one to trademarked and/or copyrighted branding and marketing materials, proven business methods and processes, training, as well as other advantages. On the other hand, these franchise benefits come at a cost in the form of upfront and ongoing payments to the franchisor. 

The franchisee is generally obligated to make two types of payments to the franchisor: a franchise fee and a royalty. The franchise fee is usually paid in full upon entering into the agreement. The royalty is typically a periodic contingent payment calculated as a percentage of gross revenues. These costs, as well as other common upfront and continuing payments, are discussed below.

Initial and One-Time Costs

The upfront franchise fee is not immediately deductible for tax purposes because it relates to an intangible asset with a useful life that extends beyond the current year. Accordingly, the fee is amortized over 15 years. A franchisee will usually achieve better after-tax cash flows during the start-up and growth stages to the extent (s)he purchases a franchise with a relatively low franchise fee, even if the lower upfront charge is offset by proportionately larger royalty payments. The interplay of the long-term deductibility of the fee and the immediate deductibility of the royalty payments should be carefully modeled to understand the impact on after-tax cash flows.

In addition to the franchise fee, a franchisee often is required to purchase inventory, furniture, equipment, and fixtures from the franchisor, as well as to pay for up-front training fees. The franchisee can create larger initial tax deductions, which may help alleviate cash flow strains during the initial start-up phase, by negotiating a favorable allocation of these costs for tax purposes. This allocation is documented on IRS Form 8594. 

Similar to the franchise fee, organizational and start-up costs (e.g., legal and consulting fees) must be amortized over 15 years, subject to an exception allowing an initial deduction of up to $5,000 of organizational costs and $5,000 of start-up costs. Costs incurred for depreciable assets such as tangible personal property and real estate may be recovered much more quickly than amortized expenses due to the Sec. 179 and accelerated depreciation deductions.

Recurring Costs

When payments are made in substantially equal or fixed amounts over the life of a franchise agreement, they can be deducted rather than capitalized if they qualify as contingent serial payments. Periodic payments contingent on sales of goods or services sold under the franchise (or some other variable measure of the franchise’s financial performance) meet this test and are currently deductible.  Contingent payments that fail to qualify as contingent serial payments must be capitalized into the basis of the franchise, which defers any tax benefit until later years. Accordingly, royalty payments under a typical franchise agreement and recurring operating costs are deductible in the year incurred. 

It’s important to note that a franchise agreement that provides for little or no franchise fees and, instead, casts all or most of the franchisee’s payments to the franchisor as royalties, may be subject to IRS re-characterization to require a portion of the royalties to be capitalized instead of expensed.

State Tax Issues

Franchisees with business operations in multiple states should also consider the impact of sales and use taxes, taxes on net income or gross receipts, occupational taxes, and property taxes, among other state and local tax issues. Most states use a combination of factors that includes payroll, capital and sales to allocate tax to the business’ entire net income. It may surprise some franchisees that the presence of capital in a state plays a role in the allocation of income to that state. To the extent a capital investment is made in a state, exposure to state income tax may increase without a corresponding increase in revenue.

Prior to initiating activities of any kind in a state, franchisees should consult with their tax advisor to quantify the likely impact on state taxes. While the overall economic benefits of expansion into a high-tax state often justify venturing in to a new jurisdiction, these decisions should be informed by thorough tax analysis to avoid unintended outcomes.

In Closing

Understanding the tax ramifications of investing in a franchised business is essential for maximizing the after-tax cash flows available. In some cases, the additional taxes paid due to a 15-year amortization of an expenditure (instead of an immediate deduction in full) may be the difference between success and failure of the venture.