A tax break for franchise purchasers

Nation's Business, March, 1993 by Albert B. Ellentuck

How to keep taxes from trapping you.

During these difficult economic times, more and more franchise businesses are being put up for sale by the original franchisees. When a franchise business is purchased, the buyer would do well to consider the tax implications of the purchase.

Typically, a purchase of a franchise business includes the franchise rights, trademarks, trade names, furniture, fixtures, equipment, and inventory. The purchaser may amortize for tax purposes the portion of the purchase price properly allocated to the franchise right.

In a recent Tax Court case involving McDonald's restaurants, Canterbury vs. Internal Revenue Service, the purchasers had acquired 16 restaurants at a total cost of about $6.5 million. The taxpayer had allocated a substantial part of the purchase price to the franchise rights, which the IRS challenged. The Tax Court subtracted $1.6 million for the tangible assets purchased and $400,000 for the going-concern value, and it held that the balance of $4.5 million should be allocated to the franchise rights.

The IRS then argued that the $4.5 million included other intangible assets such as good will, which cannot be amortized at all for tax purposes.

The Tax Court disagreed, saying that the good will was not an asset "separate and apart from the good will inherent in the McDonald's franchise." The McDonald's system heavily emphasizes quality and uniformity, which involves training sessions and advertising as well as significant quality controls. The court said that the right to use the McDonald's system, trade name, and trademarks are all part of the McDonald's franchise and cannot be divided and sold separately.

Accordingly, the court held that the full $4.5 million was to be considered as paid for the franchise right and could be amortized by the taxpayer over 10 years.

Although in this case the amounts allocated to the franchise rights were allowed to be amortized over 10 years, the law was amended in 1989 to require that franchises costing more than $100,000 must be amortized over 25 years.

For franchises purchased from another franchisee for $100,000 or less, the Canterbury decision will be very helpful.

For franchises costing more than $100,000, a 25-year write-off is better than no write-off at all. The final version of the 1992 Tax Act, which was vetoed by President Bush, contained a provision that would have allowed intangible assets, including good will, to be amortized over a 14-year period.

This proposal was recently reintroduced in the House of Representatives. If it is enacted, the distinction between franchise rights and good will would be eliminated for future purchases.

In view of the significant effect on the tax consequences, careful planning is essential in structuring franchise agreements and in allocating the purchase price. See your tax attorney.