Investing in a franchise is a great way to go into business without exposing yourself to the risks of running your own start-up. Franchises have a greater chance of success and also benefit from the reputation of an established company. This saves the investor some of the work of creating a customer base. Of course, like any business opportunity, investing in a franchise comes with its fair share of drawbacks. Not least, it can make doing your taxes a real headache. Many franchise newcomers don’t know which aspects of franchise expenditure are tax deductible and which aren’t. So the most important question of all is are franchise fees tax deductible?
A franchise is the exclusive right to operate a branded business in a specific geographic area. To operate a franchise, you pay rights fees to the brand holder, or "franchisor." The tax code recognizes two kinds of franchise costs: initial and ongoing.
Initial franchise fee: The initial payment secures the use of the company’s name and any slogans, logos, or other trademarked materials. It can also cover training. You can amortize your franchise fee on a yearly basis. Before you can amortize it, you must determine the correct amount to deduct. You calculate your yearly amortization amount by dividing the total franchise fee by its useful life.
For example, your $50,000 franchise fee has a useful life of 10 years. Calculate the yearly amortization amount by dividing $50,000 by 10 years, or $5,000 per year. To record the amortization at the end of your accounting year, debit your Franchise Fee Amortization account for $5,000 and credit your Franchise account by $5,000.
Ongoing service fee: After securing the franchise, an investor can expect to pay a regular service fee for the ongoing use of the franchise. This is usually based on sales rather than profits and is typically around 7-8%. You can choose to amortize your franchise fee on a monthly basis rather than once a year. To calculate the monthly amortization, divide your yearly amortization amount by 12 months.
For example, if your yearly amortization is $2,400, divide that by 12 months to get your monthly amortization of $200. To record the monthly amortization, debit your Amortization account for $200 and credit your Accumulated Amortization account by $200. You must continue to amortize your franchise fee the same way whether you select a yearly or monthly amortization schedule.
It is important to recognise the difference between these two types of expenditure since they get different tax treatment. .
Accounting for the franchise fee lets you recognize your costs so you can deduct those amounts on your business income tax return.
The initial franchise fee counts as capital expenditure and is therefore not tax deductible. This is regardless of whether you pay in one or several instalments. This is also the case for any legal fees relating to the initial payment.
Ongoing service fees are revenue expenses rather than capital expenditure. That means there is an allowable deduction.
In conclusion, to put it simply, initial franchise fees are not deductible but ongoing service fees are.