Citrin Cooperman Partners Paul Dailey and Elaine Papadopoulos discuss the recognition of franchise fees from both accounting and tax perspectives.

1. FRANCHISE FEE PITFALLS AND HOW
TO IDENTIFY THEM
FOCUS ON WHAT COUNTS
[ENTREPRENEURIAL]
[PROGRESSIVE]
[SOLUTIONS]

2. TODAY’S PRESENTERS
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Elaine Papadopoulos, CPA
Partner
212-697-1000 x1323
epapadopoulos@citrincooperman.com
Paul H. Dailey, CPA
Partner
212-697-1000 x1442
pdailey@citrincooperman.com

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

4. 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.

5. 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)]

6. RULES, RULES, RULES
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First reaction to collecting franchise fees:
DEPOSIT
SPEND
SHOWING GREAT NET INCOME
Reality:
DEPOSIT
CONSIDER SPENDING
POSSIBLY ESCROWING
DEFERING

7. 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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8. 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

9. ACCOUNTING Q&A

10. TAX TREATMENT FOR
DEFERRED REVENUE

11. 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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12. 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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13. 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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14. 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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15. 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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16. TAX – ADVANCE PAYMENT (CONT’D)
• Does not include:
• Rent
• Insurance premiums
• Financial instruments
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17. 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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18. 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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19. TAX – CHANGE IN ACCOUNTING METHODS
• Automatic consent procedures
• Audit protection
• Sec. 481(a) adjustment
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20. 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

21. TAX Q&A

22. THANK YOU
PAUL DAILEY AND ELAINE PAPADOPOULOS