Income Tax Considerations in Acquisitions and Combinations of Franchise Businesses

• Author: Michael J. DeLaurentis and Will K. Woods
• Pages: 175-221

I. INTRODUCTION

The income tax considerations relevant to the acquisition or disposi‑

tion of a franchise business are essentially the same as those relevant

to acquisitions or dispositions of any other operating business.1 The

principal distinguishing feature of a transfer involving a franchise busi‑

ness is the franchise itself: the bundle of (a) related assets and rights

captured in trade names, copyrights, patents, trade secrets, other intel‑

lectual property, and agreements with franchisees, and (b) the related

obligations to provide ongoing support to franchisees.

This chapter focuses on the principal federal income tax consider‑

ations that typically arise in connection with the sales or transfers of

entire franchise businesses by the franchisor, with limited reference to

the taxation of franchise operations or to transfers by franchisees of

franchise businesses.2 Practitioners should also consider the possible

1. Tax aspects of acquisitions or dispositions involving franchises sub‑

ject to specic industry legislation, such as automobile dealers and alcoholic

beverage distributors, are outside the scope of this discussion.

2. The principles involved with franchisee transfers to another or new

franchisee are nevertheless the same, though before the IRS publicly ruled on

the issue, there had been some uncertainty that this was so. See Rev. Rul. 88‑24,

1988‑1 C.B. 306; see also I.R.S. Tech. Adv. Mem. 86‑30‑002 (Jan. 21, 1986); I.R.S.

Gen. Couns. Mem. 39,539 (Jan. 22, 1986); I.R.S. Priv. Ltr. Rul. 8735082 (June 1,

1987) & 8735083 (June 6, 1987).

175

Income Tax Considerations in

Acquisitions and Combinations of

Franchise Businesses

Michael J. DeLaurentis and Will K. Woods

6

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application of federal excise taxes and various state and local income and other

tax aspects of the transfer of a franchise operation. The issues addressed are

those most likely to be encountered by any transferor or transferee of such an

operation; this is by no means an exhaustive treatment of all income tax issues

that might arise. Detailed consideration even of these major issues would require

an entire volume. Accordingly, it is the highlights that will be addressed here, the

hope being that competent tax advisers will be consulted early in the process of

considering the acquisition or disposition of a franchise business.

II. PRELIMINARIES

A. Tax Treatment of Franchise Transfers in General

The central assets in the transfer of a franchise business are the franchise agree‑

ments and related trade/service marks, trade names, and possibly other protected

or unprotected intellectual property. Nearly all of these items are likely to fall

within the purview of Sections 1253 (Transfers of Franchises, Trademarks, and

Trade Names) and 197 (Amortization of Goodwill and Certain Other Intangibles)

of the Internal Revenue Code.

A franchise agreement generally provides that the franchisor will license certain

trademarks and guidelines concerning quality control of a standardized product

or service and the general operational, and likely physical, format of the fran‑

chised business. In return, the franchisee is typically required to pay an upfront

franchise fee and continuing periodic royalties, normally stated as a percentage

of gross revenues of the franchisee for a specied period.

For purposes of the federal franchise laws and most state franchise laws, the

three key elements of a franchise are the license of (or the right to associate with)

a trademark, the provision or signicant assistance to the franchisee or the right

to exercise signicant control over the franchisee, and the payment of a fee. By

contrast, for federal income tax purposes, “[t]he term ‘franchise’ includes an

agreement which gives one of the parties to the agreement the right to distribute,

sell, or provide goods, services, or facilities, within a specied area.”3

3. I.R.C. §1253(b)(1) (Lexis 2013). The same meaning applies for purposes of I.R.C.

§197 (Lexis 2013) (I.R.C. §197(f)(4)(A)(Lexis 2013)). Prior to enactment of Omnibus Budget

Reconciliation Act of 1993, Pub. L. No. 103‑66, 107 Stat. 312, the IRS had argued unsuc‑

cessfully that “public” franchises (like cable television licenses) were not included within

this denition. See, e.g., Tele‑Communications, Inc. v. Comr., 12 F.3d 1005 (10th Cir. 1993),

acq., AOD 1996‑005; Jefferson‑Pilot Corp. v. Comr., 98 T.C. 435 (1992), aff’’d, 995 F.2d 530

(4th Cir. 1993); cf. I.R.C. §197(d)(1)(D) (Lexis 2013) (“any license, permit, or other right

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A franchise, whether self‑created or acquired by purchase or other transfer, is

generally amortizable,

4

and therefore excluded from the denition of a “capital

asset” under I.R.C. §1221.

5

Because franchise rights are used in a trade or busi‑

ness, however, if these franchise rights are disposed of in a taxable disposition,

the gain or loss realized will be subject to the special rules of I.R.C. §1231, which

generally provides that gains are treated as long‑term capital gains and losses as

ordinary losses.

6

For a transferor other than a C corporation, favorable capital

gains rates would apply to net section 1231 gains (subject to the other special rules

for determining the amount of and tax on capital gains under I.R.C. subchapter P,

I.R.C. §§1201 et seq.), currently generally 15 percent.7 Under current law, corporate

net capital gain is generally taxed at the same rate as ordinary income.8 Moreover,

granted by a governmental unit or an agency or instrumentality thereof” is an “amortiz‑

able section 197 intangible”). Sports franchises and player contracts were excluded from

the denition of “amortizable section 197 intangible” for transfers prior to October 22,

2004. (Pub. L. 108‑357, Sec. 886(a)).

4. I.R.C. §197(d)(1)(F) (Lexis 2013) (a franchise is an “amortizable section 197 intan‑

gible”); id. §197(f)(7) (amortizable section 197 intangibles “shall be treated as property

which is of a character subject to the allowance for depreciation provided in section 167”).

5. Id. §1221(a)(2). Notice that a franchise, when transferred as part of a business,

will virtually never be a capital asset, even if self‑created, unlike nearly all other self‑cre‑

ated intangibles. Self‑created intangibles, with three exceptions, are excluded from the

denition of “amortizable section 197 intangibles.” Id. §197(c)(2). Franchises are one

of the exceptions. Id. §197(c)(2)(A). Accordingly, costs of developing a franchise must

be amortized over 15 years, even if they might otherwise be currently deductible. See

Treas. Reg. §1.197‑2(d)(2)(iii)(A) (as amended in 2013) (“Thus, for example, capitalized

costs incurred in the development, registration, or defense of a trademark or trade name

do not qualify for the exception and are amortized over 15 years under section 197.”).

As explained in the text and the following note, gain on disposition of a franchise may

nevertheless be treated as capital gain in many circumstances. Franchises that escape

amortization by reason of being held for sale as inventory are ipso facto not capital assets

and therefore not eligible for capital gain treatment. Under current law, only a franchise

that is never amortized and is sold in isolation from any other assets is likely to have a

chance for classication as a capital asset.

6. The computation is somewhat more complex than this. If gains from section 1231

assets exceed losses from such assets, they are both treated as long‑term capital items

(netted, along with other capital gains and losses in accordance with the rules under

subchapter P of the I.R.C.) (I.R.C. §§1201 et seq., Lexis 2013). Otherwise, both gains and

losses are treated as items of ordinary income or loss. These computations are done before

taking into account carryover of losses, if any, from other years. Moreover, net section

1231 gains for a year will be treated as ordinary to the extent the taxpayer had net sec‑

tion 1231 losses in any of the ve years preceding the year of net section 1231 gains. An

amortizable section 197 intangible is also “section 1245 property,” and therefore subject

to the general rules applicable to recapture of depreciation as ordinary income in speci‑

ed circumstances. Finally, I.R.C. §1239 will apply to any gain recognized upon the sale or

exchange of a franchise to certain “related persons” (as dened in I.R.C. §1239(b) (Lexis

2013)), resulting in ordinary‑income treatment.

7. For noncorporate taxpayers in a bracket below 25 percent, the rate applicable

to net capital gain is ve percent (zero percent through 2012).

8. The same rate applies to S corporations with built‑in gains. See I.R.C. §1374 (Lexis

2013).

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