Franchise

[Bonnie]

Customer who opened a local coffee shop a little over a year ago is asking me for tax advice. They are thinking of doing a franchise and are wanting to know how this would affect their tax situation. They would be the one who granted the franchise and someone else would be the the franchisee. How would the upfront fee they receive be reported on the tax return? Also how would the royalties be reported? I have never dealt with anything like this before so I would appreciate any help anyone can give me.

Thanks
Bonnie

[Golden Rocket]

Refundable

Bonnie, is the franchise fee refundable?

If not, I believe it probably falls in the category of constructive receipt, i.e. revenue in the year received.

[Gene V]

Following are some paragraph from West Federal Taxation 2008

For Federal income tax purposes, a franchise is an agreement that gives the franchisee the right to distribute, sell,
Or provide goods, services, or facilities within a specified area. (§1253(b)(1). A franchise transfer includes the grant of a franchise, a transfer by one franchisee to another person, or the renewal of a franchise.

A franchise transfer is generally not a sale or exchange of a capital asset. Section 1253 provides that a transfer of a franchise, trademark, or trade name is not a transfer of a capital asset when the transferor retains any significant power, right, or continuing interest in the property transferred.

Noncontingent Payments. When the transferor retains a significant power, right, or continuing interest, the transferee’s noncontingent payments to the transferor are ordinary income to the transferor. The franchisee capitalizes the payments and amortizes them over 15 years. The amortization is subject to recapture under §1245.

Grey Company signs a 10-year franchise agreement with DOH Donuts. Grey (the franchisee) makes payments of $3,000 per year for the first 8 years of the franchise agreement—a total of $24,000. Grey cannot deduct $3,000 per year as the payments are made. Instead, Grey may amortize the $24,000 total over 15 years. Thus, Grey may deduct $1,600 per year for each of the 15 years of the amortization period. The same result would occur if Grey made a $24,000 lump-sum payment at the beginning of the franchise period. Assuming DOH Donuts (the franchisor) retains significant powers, rights, or a continuing interest, it will have ordinary income when it receives the payments from Grey.

[Gene V]

Part 2.

Contingent Payments. Whether or not the transferor retains a significant power, right, or continuing interest, contingent franchise payments are ordinary income for the franchisor and an ordinary deduction for the franchisee. For this purpose, a payment qualifies as a contingent payment only if the following requirements are met:

*The contingent amounts are part of a series of payments that are paid at least annually throughout the term of the transfer agreement.
*The payments are substantially equal in amount or are payable under a fixed formula.

TAK, a spicy chicken franchisor, transfers an eight-year franchise to Otis. TAK retains a significant power, right, or continuing interest. Otis, the franchisee, agrees to pay TAK 15% of sales. This contingent payment is ordinary income to TAK and a business deduction for Otis as the payments are made.

You can read information on Franchise in Pub. 544 page 23 and Pub. 535 pages 28 and 42