Taxation of pooled franchise advertising funds
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 a franchise advertising fund, and to qualify for an agency exemption, four criteria must be met:
- Contributions can’t 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 franchise advertising programs aren’t considered income for products or services but rather contributions held in trust. As a result, they aren’t taxable.
The specific nature of an advertising relationship isn’t addressed in the Internal Revenue Code; instead, it’s been developed through case law. A defining case relating to franchise funding of pooled advertising 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 franchise advertising fees in the form of payments that exceeded the prevailing price of the extract. The excess payments were then held in trust in a franchisor advertising fund administered by the taxpayer and solely utilized for advertising and promotional activities.
The specific nature of an advertising relationship isn’t addressed in the Internal Revenue Code; instead, it’s been developed through case law.
The court ruled that the payments made by bottler franchisees for franchise advertising weren’t 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 weren’t income to Seven-Up.
The IRS clarified the nature of franchise advertising fees 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.
When considering the pooled use of funds, it’s important to note that the federal tax treatment may not extend to state taxation. The concept of an agency exemption doesn’t exist in all jurisdictions, and careful planning must be given to jurisdictions that impose a tax based on gross receipts. The federally exempt funds can be — and are — subject to some gross receipts-based taxes, creating an unexpected liability for unwary taxpayers.
When considering the pooled use of funds, it’s important to note that the federal tax treatment may not extend to state taxation.