Many franchisors aren’t aware that, in some cases, the tax rules treat third-party franchise broker commissions differently from other expenses. Do you know the difference? Unlike other expenses that can be deducted, the commissions paid to brokers may need to be capitalized in year one of the franchise agreement. For some franchisors, this can result in a significantly decreased tax deduction even though the full commission is paid in that year. Failing to defer the expense can result in an unexpected tax bill.
What are the franchise tax rules relating to broker commissions expense?
Under the tax rules, franchise agreements are deemed to provide the franchisor with “intangible agreement rights” under Reg. Section 1.263(a)-4(d)(6) of the tax code. In this situation, costs paid to third parties for finder fees, site fees, etc., are regarded as “facilitative” under 1.263(a)-4(e), and therefore need to be capitalized, unless de minimis. Commissions paid to third-party brokers are comparable to finder fees in the eyes of the IRS and have historically been treated similarly under these regulations. Under Sec. 1.263(a)-4(d)(6)(v), the costs are de minimis if the aggregate of all amounts paid to third parties under an agreement doesn’t exceed $5,000. Note there are various methods for aggregation and pooling of agreements, so consult with your tax advisor to determine whether your commissions are de minimis.
How can I maximize deductions related to franchise broker commission expenses?
Consider these strategies to maximize deductions in year one:
- Use an employee instead of an independent contractor: If the work in question can be performed by an employee rather than a third-party contractor, the associated expenses of wages and any employee commissions are deductible in the year the store opens.
- Set up broker contracts with commissions under the de minimis threshold: In this scenario, they can be expensed right away, and there’s no requirement to capitalize the expense over the life of the contract.
The bottom line on deferred commissions
There’s a potential trap for franchisors expecting to immediately expense all broker fees in year one of a franchise agreement. Be sure you understand the IRS tax rules and plan ahead to avoid negative cash flow and ensure compliance in case of an IRS audit.
