FRANCHISE FEE PITFALLS AND HOW

TO IDENTIFY THEM

FOCUS ON WHAT COUNTS

[ENTREPRENEURIAL]

[PROGRESSIVE]

[SOLUTIONS]

TODAY’S PRESENTERS

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Elaine Papadopoulos, CPAPartner212-697-1000 x1323epapadopoulos@citrincooperman.com

Paul H. Dailey, CPAPartner212-697-1000 x1442pdailey@citrincooperman.com

AGENDA

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• Franchise fees• Recognition of franchise fees (Accounting vs Tax)• Who is regulating how they are recognized?• Examples• Q&A

FRANCHISE FEES

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What are initial franchise fees?

Consideration for establishing the franchise relationship and providing some initial services. Occasionally, the fee includes consideration for initially required equipment and inventory, but those items usually are the subject of separate consideration.

When are franchise fees collected?

These fees are obtained through a franchise agreement

The payment of an initial franchise fee is not a necessary criterion for an agreement to be considered a franchise agreement.

FRANCHISE FEES (CONT’D)

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What are initial services?

Common provision of a franchise agreement in which the franchisor usually will agree to provide a variety of services and

advice to the franchisee, such as the following:

Assistance in the selection of a site. The assistance may be based on experience with factors such as traffic patterns,

residential configurations, and competition.

Assistance in obtaining facilities, including related financing and architectural and engineering services. The facilities

may be purchased or leased by the franchisee, and lease payments may be guaranteed by the franchisor.

Assistance in advertising, either for the individual franchisee or as part of a general program.

Training of the franchisee's personnel.

Preparation and distribution of manuals and similar material concerning operations, administration, and record

keeping.

Bookkeeping and advisory services, including setting up the franchisee's records and advising the franchisee about

income, real estate, and other taxes or about local regulations affecting the franchisee's business.

Inspection, testing, and other quality control programs.

[Above from FAS 45: Accounting for Franchise Fee Revenue (as amended)]

RULES, RULES, RULES

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First reaction to collecting franchise fees:

DEPOSIT SPEND

SHOWING GREAT NET INCOME

Reality:

DEPOSITCONSIDER SPENDINGPOSSIBLY ESCROWING

DEFERING

RECOGNIZING FRANCHISE FEES FOR YOUR BOOKS

Under FASB codification 952-605-25 Recognition:

Franchise fee revenue from an individual franchise sale shall be recognized, …, when all material services or conditions relating to the sale have been substantially performed or satisfied by the franchisor.

Substantial performance for the franchisor means that all of the following conditions have been met:

a. The franchisor has no remaining obligation or intent—by agreement, trade practice, or law—to refund any cash received or forgive any unpaid notes or receivables.

b. Substantially all of the initial services of the franchisor required by the franchise agreement have been performed.

c. No other material conditions or obligations related to the determination of substantial performance exist.

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YOUR BOOKS

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My Awesome Franchise Concept

Balance Sheet

December 31, 20X1

Assets

Cash $ 80,000

Prepaids 12,000

Other Assets 2,500

Total assets $ 94,500

Liabilities and Equity

Deferred franchise fees $ 100,000

Equity (5,500)

Total liabilities & equity $ 94,500

Facts:

• Invested $9,000

• Sold a franchise for a fee of $100,000

• Used invested amounts plus some of the fee to pay for certain expenses related to selling the franchise and other assets

ACCOUNTING Q&A

TAX TREATMENT FOR

DEFERRED REVENUE

TAX GUIDANCE

The recognition of deferred revenue poses specific challenges for the Franchise sector. GAAP and tax treatment have their own separate rules. By understanding the various rules, you will be able to plan proactively so as to avoid surprises. From a tax perspective, only limited deferral is allowed. Specifically, tax issues to be addressed revolve around the limited deferral as provided for in Rev. Proc. 2004-34.

General rule requiring current recognition of deferred revenue.

1. One year lag rule

2. Definition of advance payments

3. Definition of qualified taxpayers

4. Change in accounting methods

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TAX – GENERAL PRINCIPLES

• Tax provides for a major departure from GAAP treatment

• Matching principle essentially ignored

• General rule is that accrual basis taxpayers report the advance payment in year of receipt, notwithstanding when earned

• Cash basis taxpayers will always reflect advance payments as income, when received

• Taxpayers are not overly excited to report income prior to inclusion for GAAP purposes.

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TAX – REV. PROC. 2004-34

• Exception provided to the general rule

• Definitive guidance offered (Yes, that is right – it is definitive!)

• Can use the full inclusion method (which is otherwise the general rule) OR the deferral method

• Under the latter method, a limited deferral is provided

• Referred to as the one year lag rule

• Essentially, you will follow GAAP for the year of receipt and then you pick up the balance of the advance payment in the second succeeding tax year.

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TAX – QUALIFICATION

• Must receive an advance payment. An advance payment is defined as a payment.

• The taxpayer includes in gross income for the taxable year of receipt under a permissible method of accounting BUT

• The taxpayer recognizes in revenue in its Applicable Financial Statement (AFS) for a subsequent year OR if no AFS, the taxpayer recognizes when earned.

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TAX – ADVANCE PAYMENT

• Must be for:• Services• Sale of goods UNLESS using the deferral method for merchandise as

provided in Reg. Sec. 1.451-5(b)(1) (ii)• Use of intellectual property (such as copyrights, patents,

trademarks and names, franchise rights, etc.)• Occupancy of property BUT only if ancillary to the provision of

services• Computer software• Guaranty or warranty contracts ancillary to the otherwise qualifying

advance payments• Subscriptions UNLESS under the special election rules of Sec. 455• Membership dues UNLESS the election rules of Sec. 456 applies;

and• Eligible gift cards

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TAX – ADVANCE PAYMENT (CONT’D)

• Does not include:

• Rent

• Insurance premiums

• Financial instruments

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TAX – APPLICATION

• The deferral rule is clear. Essentially, one must report the advance payment over a two year period for tax purposes.

Examples – Assume taxpayer receives a $10M advance payment in 2016

• GAAP treatment provides for ratable amortization (coinciding with when deemed earned) 10% per year

• TAX result - $1M reflected in 2016 and $9M in 2017• GAAP – 1/3 amortization

• TAX result – 1/3 in 2016 and 2/3 in 2017• GAAP – ¼ amortization, but only commencing in 2017

• TAX result - $10M reflected in 2017

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TAX – AFS

• Financial statements required by the SEC (i.e. 10-K)

• Certified audited financial statements

• Financial statements required by the Federal or State government or agency

Without an AFS or if unable to determine the extent to which the advance payments are recognized in revenue in the AFS for the tax year of receipt,

taxpayer MUST include the advance payment in gross income for the tax year of receipt to the extent earned in that year AND include the remaining

amount of the advance payment in gross income for the next succeeding year.

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TAX – CHANGE IN ACCOUNTING METHODS

• Automatic consent procedures

• Audit protection

• Sec. 481(a) adjustment

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REAL DIFFERENCES BETWEEN BOOKS AND TAX

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Books:

Could be deferring for more than one year

Tax:

Paying tax on income that you may have

escrowed or you can’t recognize for books

TAX Q&A

THANK YOU

PAUL DAILEY AND ELAINE PAPADOPOULOS