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Sale of a Franchise

Technical topics regarding tax preparation.
#1
IDCPA  
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Client several years ago started a small restaurant chain, operating the individual businesses for 18-24 months and then selling each business. Rinse, repeat.

Client is new to me and I want to make sure i'm treating these transactions properly (don't believe they did in prior years).

Equipment has an original cost of $150K, less $20K of depreciation. No other tangible assets being transferred.

Agreement spells out the $300K of proceeds as allocated $140K towards Equipment, $130K as Goodwill and $30K as a Franchise fee.

Seller continues to receive 1% of sales as a franchise fee, and obviously retains the right to sell other franchises.

Add to that this is an installment sale - with $160K down and $140K on installment over 28 months (no interest).

It's my understanding because they receive contingent payments and retain franchise rights, the $30K franchise fee and subsequent fee income would all be ordinary income.

So, my main question is how to allocate the proceeds:

Am I correct that the first $30K of cash received would be for the franchise fee (ordinary income), the next $10K would be 1245 recapture (ordinary), leaving for the installment sale $260K of proceeds against capital assets with a basis of $130K - a 50% gross profit percentage.

Prior to any additional installment payments, we would have $120K of proceeds, and thus in total $60K of LT capital gain and $40K of ordinary income (recapture plus franchise fee)?

Am I missing something? (just once I'd like the answer to be "No. Perfect IDCPA"....braces for impact...)

TIA
 

#2
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I haven't looked, but I'll ask this. Do you lump the installment sale as one sale of assets, or do you look at each asset separately (goodwill, equipment, etc.). And the equipment is a 1231 asset, not a capital asset. And do you need to impute interest under section 483?
 

#3
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Agree on 1231. I mistyped. And yes, I'm aware of the 483 requirement. I left it out of my question for simplicity, but I appreciate you bringing it up.

But as for bifurcating the sale I'm not sure how it should be handled.

I want to say the Goodwill should have proceeds of $130K, with no basis. And the equipment should have proceeds of $140K with a basis of $130K. After recognizing $30K of franchise fee income, the remaining current year proceeds $130K would be first allocated to the 1245 recapture ($10K) and the remaining $120K would be split prorata between the equipment and the Goodwill. In this case remaining proceeds of $130K each would mean we apply the $120K 50/50 - $60K of proceeds for each.

But I'm not confident in that answer. Would appreciate some guidance. Thanks.
 

#4
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What I don’t quite follow is that you gave fixed numbers for consideration and then said there’s a contingent element.

And is there not a franchise fee on the books that you’ve been amortizing down?
 

#5
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We'll have to see the answer. I understood the facts to be that client is the franchisor.
 

#6
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They are the franchisor. Created the brand more or less.
 

#7
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Jeff-Ohio wrote:What I don’t quite follow is that you gave fixed numbers for consideration and then said there’s a contingent element.

And is there not a franchise fee on the books that you’ve been amortizing down?


Not sure how to answer your first question - 'yes', I suppose??

There is a fixed fee and continuing contingent fees. Not sure if you're suggesting they should be part of the installment sale proceeds? I'm assuming they are simply ordinary income when received, just like my assumption on the $30K initial franchise fee.
 

#8
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I understood the facts to be that client is the franchisor.

That makes sense. So maybe what we have here is “corporate-owned” franchise, if you will, with respect to each individual location…that will be sold off to independent owners/operators.

I still don’t follow the contingent element, though.
 

#9
Nilodop  
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Section 1253 covers treatment of sale of a franchise. This recent case, https://www.ustaxcourt.gov/ustcinop/opi ... x?ID=11288, has some pretty good analysis of how to apply 1253. It's taxpayer-favorable for capital gains treatment, but its facts are different from OP's. The case has this clause in it:
Everything seemed fine until the Commissioner showed up in 2009, ...
. I did not know IRS was so short of agents that the Commissioner had to do audits personally.
 

#10
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Not sure how to answer your first question


Why not? You state that the sale is for $300k. And then you say, “Because they receive contingent payments…”

If the sale is for an agreed-upon and fixed $300k, what is contingent about that?

Is the 1% Royalty the contingent consideration you speak of? And are you saying that said Royalty is above and beyond the $300k?

And then you say this:

I'm assuming they are simply ordinary income when received, just like my assumption on the $30K initial franchise fee.


On the one hand, you’re talking about the 1% Royalty being contingent consideration for the sale of assets. And on the other hand, you’re talking about it being separate from the sale.
 

#11
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Nilodop wrote:Section 1253 covers treatment of sale of a franchise. This recent case, https://www.ustaxcourt.gov/ustcinop/opi ... x?ID=11288, has some pretty good analysis of how to apply 1253. It's taxpayer-favorable for capital gains treatment, but its facts are different from OP's. The case has this clause in it:
Everything seemed fine until the Commissioner showed up in 2009, ...
. I did not know IRS was so short of agents that the Commissioner had to do audits personally.


I've read through the facts of that case, and yes it's taxpayer friendly, but the facts differ (as memory serves) because Greenwaste gave away the franchise, with no contingent payments or rights.

Which is why I mentioned in the OP they have the contingent/royalty fee and the ability to sell additional franchise rights...
 

#12
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Jeff-Ohio wrote:

Is the 1% Royalty the contingent consideration you speak of? And are you saying that said Royalty is above and beyond the $300k?

On the one hand, you’re talking about the 1% Royalty being contingent consideration for the sale of assets. And on the other hand, you’re talking about it being separate from the sale.


Sorry if my fact pattern isn't clear. I guess I'm not sure why it matters and I'm hoping you'll clarify.

Yes, the 1% is the contingent consideration I'm referring to.

The facts are they are selling the business assets for $300K, including a $30K franchise fee. and they also receive a 1% royalty.

The purchase agreement actually makes no reference to the 1% royalty, but it's definitely part of the contractual arrangement (they have sold in prior years 3 franchises and continue to collect the 1% monthly).

For all intents and purposes though it is a separate transaction. I'd like to not consider the 1% royalty in the installment sale and just report it as ordinary income...
 

#13
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I guess I'm not sure why it matters and I'm hoping you'll clarify.


Because when you have contingent consideration involving a sale of assets, special rules dictate how and when you recover your basis. Furthermore, you have different classifications of assets here, giving rise to different types/character of gain. If you add contingent consideration into the mix, it impacts the gain amounts. In other words, if there really was contingent consideration, some would go to the equipment, some to the goodwill, some to the franchise.

Anyway, I agree with you. I don’t see any contingent consideration here based on your clarification.

I tend to think the “Franchise Fee” (the $30k) is ordinary income, but I might dispute that it’s all taxable in the year of sale. The quirk is that we’re dealing with a franchisor here. I’m thinking that this thing gets reported based on accounting method. What if franchisor “sold a franchise” for $30k to a franchisee and said, “Pay me $10k per year for each of the next 3-years.” Should all $30k really be taxable in Year1? If so, on what grounds? Would franchisor’s overall accounting method matter?

Once we figure this out, we can move forward.
 

#14
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I am with IDCPA that the 30k and the 1% are royalties, and separate from the rest of the sale. (Perhaps a part of this is a non-compete agreement, but ordinary income nonetheless.)

I would treat the franchise fee, sale of equipment, and sale of goodwill as three separate transactions and, unless the contract stipulates otherwise, treat each payment as proportional to the agreed allocation:

Down payment: 160k -> 16,000 Franchise Fee, 74,667 Equipment(incl. interest), 69,333 Goodwill(incl. interest)
Monthly installment: 5k -> 500 Franchise Fee, 2,333 Equipment(incl. interest), 2,167 Goodwill(incl. interest)

The franchise fee is ordinary income (probably royalties) as it is received. Using the June 2018 AFR of 2.32%, the PV of the equipment purchase is 138,204 and the PV of the goodwill purchase is 128,331. For the equipment, there is 8,204 of ordinary income recapture, and otherwise zero gain. Thus a 6252 should not be filed for the equipment sale and only the interest needs to be claimed in the future. For the goodwill, the entire 128,331 amount is capital gain and needs to be reported on Form 6252.

I assume you are familiar with Form 8594?
 

#15
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MSchmahl wrote:I am with IDCPA that the 30k and the 1% are royalties, and separate from the rest of the sale. (Perhaps a part of this is a non-compete agreement, but ordinary income nonetheless.)

I would treat the franchise fee, sale of equipment, and sale of goodwill as three separate transactions and, unless the contract stipulates otherwise, treat each payment as proportional to the agreed allocation:

Down payment: 160k -> 16,000 Franchise Fee, 74,667 Equipment(incl. interest), 69,333 Goodwill(incl. interest)
Monthly installment: 5k -> 500 Franchise Fee, 2,333 Equipment(incl. interest), 2,167 Goodwill(incl. interest)

The franchise fee is ordinary income (probably royalties) as it is received. Using the June 2018 AFR of 2.32%, the PV of the equipment purchase is 138,204 and the PV of the goodwill purchase is 128,331. For the equipment, there is 8,204 of ordinary income recapture, and otherwise zero gain. Thus a 6252 should not be filed for the equipment sale and only the interest needs to be claimed in the future. For the goodwill, the entire 128,331 amount is capital gain and needs to be reported on Form 6252.

I assume you are familiar with Form 8594?


Thank you so much for the detailed breakdown that confirmed the treatment I think is correct in this circumstance. I appreciate you taking the time. Very helpful.

And yes, I'm all too familiar with 8594 :). Thanks again.
 

#16
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Sorry I’m late in posting this…

treat each payment as proportional to the agreed allocation: Down payment: 160k -> 16,000 Franchise Fee, 74,667 Equipment(incl. interest), 69,333 Goodwill(incl. interest)


Agreed.

Monthly installment: 5k -> 500 Franchise Fee, 2,333 Equipment(incl. interest), 2,167 Goodwill(incl. interest)


Also agree. I also ran it out over the full 28-month period, which would give us (1) $14,000 for the franchise fee [$500 x 28] (2) $65,333 for the equipment [$2,333 x 28, rounded] and (3) $60,667 for the Goodwill [$2,167 x 28, rounded]. As an overall check as to the overall consideration:

Down Pmt + Note for the Franchise Fee = $30,000;
Down Pmt + Note for the Equipment = $140,000;
Down Pmt + Note for the Goodwill = $130,000.

MSchmahl’s “monthly” idea is a good one, because it accounts for this transaction happening at some point during the year. But I ran it out as if it happened on 1/1/Year1. I get the following amount of gain (1) Year1 = $127,333 (2) Year2 = $32,000 (3) Year3 = $10,667. Total is $170,000.

For Year1…Overall equipment gain is $10k, all of which represents Sec 1245 recapture, so that entire $10k has to be recognized in Year1. Gain on goodwill down payment is $69,333. Gain on Goodwill note collections is $26,000 [$2,167 x 12…minus $0 basis]. Gain/income on Franchise Fee down payment is $16,000. Gain/income on Franchise Fee note collections is $6,000 [$500 x 12…minus $0 basis]. So, Year1 total gain/income recognition is $127,333.

One way to reconcile this, Form 6252 style, is as follows: We had a total basis is $130,000. But we had $10k of Sec 1245 recapture. We add those two together and we get $140k. Selling price was $300k. Gross profit of $160k divided by the $300k = 53.33%. Payments rec’d in Year1 (assuming a full 12-month year) would be $220,000 [$160,000 down pmt + $60,000 note collections]. $220,000 x 53.33% = $117,333, rounded. Add the $10k Year1 Sec 1245 recapture and you’re at $127,333.

I’ve ignored interest considerations. And the planning here would have been based on something MSchmahl said:

unless the contract stipulates otherwise


Specifically, what you could have done, as per the agreement, would have been allocate $140k of the down payment to the equipment and had no (deemed separate) note for the equipment. The other $20k of the down payment could have been allocated to goodwill. You would have maximized deferral that way.
 

#17
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Again, many thanks. Good to have some comfort level with my treatment. I really appreciate the time and effort for each of your posts.
 


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