Taxation of pool advertising funds
Pooled advertising funds are common in the franchise sector since the combined resources of individual franchisees can have a significant advertising impact. Auto dealers, too, are also frequently members of a pooled advertising fund. But, what exactly are pooled advertising funds; how are they defined; and what are the tax requirements?
Pooled advertising funds exist in trust for the common benefit of all stakeholders. Because of the trust relationship, all contributions and expenditures of the fund are considered tax-free.
To be considered an advertising fund, and to qualify for an agency exemption, four criteria must be met:
- Contributions cannot be payments for products or services.
- The recipient of payments must be subject to clearly defined restrictions regarding the use of funds.
- Benefits may not inure to any of the stakeholders.
- The recipient has a clear obligation to spend the funds collected.
If the relationship meets these four requirements, then stakeholder contributions received by the “fund” are not considered income for products or services but rather contributions held in trust. As a result, they are not taxable.
The specific nature of an advertising relationship is not addressed in the Internal Revenue Code; instead, it has been developed through case law. One of the defining cases commonly referenced is Seven-Up v. Commissioner. In Seven-Up, the taxpayer manufactured and sold extract to franchised bottling companies. Seven-Up launched a national advertising program that required bottler franchisees to contribute funds in the form of payments for extract that exceeded the prevailing price. The excess payments were then held in trust by the taxpayer and solely utilized for advertising and promotional activities.There are many applications for a pooled use of funds. While advertising is the most common, the law doesn't restrict entities to this purpose.
The court ruled that the payments made by bottler franchisees were not contributed for services rendered by the taxpayer, but instead, for group advertising. The court also deemed the taxpayer obligated to use the contributed funds for national advertising, with no gain or profit realized from this obligation. The court determined an agency relationship existed and ruled the payments were not income to Seven-Up.
The IRS clarified the nature of advertising funds in Private Letter Ruling 9834003, which states that contributions toward operations within an ad fund that violate the limited purpose are taxable as gross income. However, any contributions and expenditures that adhere to the fund’s purpose and restrictions should still qualify for tax-free ad fund treatment.
There are many applications for a pooled use of funds. While advertising is the most common, the law doesn't restrict entities to this purpose. If you're using — or considering — pooled funds, it's important to have a governing document that clearly reflects the nature of the entity and identifies designated uses, and restrictions on use, of the shared funds.
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