Franchise costs, including goodwill, deductible.

The manner in which the purchase price of a trade or business is allocated between amortizable (e.g., noncompetition agreements) and nonamortizable (e.g., goodwill) intangible assets is currently the subject of great controversy. Costly battles continue to rage between taxpayers and the IRS, legislative proposals rise and fall, and tax advisers struggle in the midst of this uncertainty to provide clients with sound advice regarding these controversial allocations. For a brief moment, the Tax Court provided taxpayers with some measure of certainty in this area when it upheld a significant allocation of the purchase price of McDonald's franchises to amortizable franchise fees rather than to nonamortizable goodwill (Canterbury, 99 TC No. 12 (1992)). However, due to the narrow statutory basis on which the court rested its decision, the case is unlikely to have a meaningful effect on the numerous purchase price allocation disputes ongoing between taxpayers and the Service.

In Canterbury, the taxpayers purchased McDonald's restaurant operations from existing McDonald's franchisees or from subsidiaries of McDonald's Corp. The assets purchased in each case included McDonald's franchise rights, trademarks and trade names. The total price paid to purchase each of these restaurants exceeded the value of the tangible assets acquired in each transaction, and the excess was allocated to the McDonald's franchise rights. The taxpayers amortized the amounts allocated to the franchise rights over 10 years under Sec. 1253(d)(2)(a). (Note: Sec. 1253 (d)(2) has since been amended to provide that a 10-year amortization period is available only for franchises with a cost of $100,000 or less. Franchises with a cost in excess of $100,000 are generally not amortizable unless an election is made under Sec. 1253(d)(3) to amortize the franchise cost over a 25-year period.)

The IRS determined on audit that the taxpayers' allocations to the franchise rights acquired were excessive, and disallowed a portion of the taxpayers' deductions. At trial, the Service asserted three arguments to support its position: (1) the amount amortizable by the taxpayers was limited to the original cost of the McDonald's franchises (i.e., $12,500), since that was a "perfect" market comparable that established the value of all McDonald's franchises; (2) as a matter of law, Sec. 1253(d) does not permit subsequent franchisees to amortize an amount in excess of the original franchise cost; and (3) a large portion of the purchase price should have been allocated to certain other nonamortizable intangible assets (including a significant allocation to goodwill). The Tax Court rejected each of these arguments.

With respect to the assertion that the franchise rights should have been valued at an amount equal to the original franchise fee of $12,500, the evidence showed that the true market value of a McDonald's franchise was far greater than its original cost, and that McDonald's could have charged substantially more for its franchises. However, for sound business reasons, McDonald's charged only this relatively nominal amount. The basic philosophy of McDonald' was that by charging less than market value for new franchises, (1) a long-term relationship with franchisees would be established (rather than focusing on short-term profits), (2) new franchises could maximize their prosperity by avoiding becoming saddled with debt and (3) the number of franchise applicants would remain high.

The court found no authority to support the contention that as a matter of law a subsequent franchisee may not amortize an amount greater than the franchise fee charged to the original franchisee. Quite to the contrary, Rev. Rul. 88-24 held that a subsequent franchisee could amortize the full price paid to acquire a franchise; although the facts of the ruling did not indicate whether the amount paid by the subsequent franchisee was more or less than the cost of the original franchise, the Tax Court believed that the ruling gave rise to an inference that the full price paid by the subsequent franchisee was amortizable without regard to the franchise's original cost. The court also noted that it had reached same result in two recent decisions involving facts similar to Rev. Rul. 88-24 (Jefferson-Pilot Corp., 98 TC No. 32 (1992); Tele-Communications, Inc., 95 TC 495 (1990)).

As to the assertion that the taxpayers acquired certain other nonamortizable assets, the court once again found for the taxpayer. The court agreed that the taxpayers acquired goodwill of McDonald's. The court explained that a critical distinction must be drawn, however, between goodwill embodied in the franchise, as opposed to goodwill not encompassed by or otherwise attributable to the franchise; the former is amortizable under Sec. 1253(d), the latter is nonamortizable. The court concluded that the goodwill acquired was embodied in the McDonald's franchises.

Within a week of opening a new McDonald's franchise, the restaurant's sales volume will generally reach its average weekly sales volume expected throughout its first year of business, and the sales volume in its first year of operations is typically very near to the sales volume expected over the life of the franchise. According to the court, these facts strongly suggested that any goodwill acquired was inherent in the McDonald's franchise system. (The court cited two instances in which McDonald's franchisees disassociated themselves from the McDonald's franchises, and in each instance the businesses failed within 18 months.)

Moreover, McDonald's quality, consistency and service also created goodwill that was inherent in the McDonald's trademarks and trade names. Because the right to use the McDonald's system, its trade names and trademarks is the essence of a McDonald's franchise, and because the rights and benefits conferred by a McDonald's franchise cannot be disposed of by a franchisee without disposing of the franchise itself, the court concluded that the taxpayers did not acquire any goodwill separate, and distinct from the goodwill inherent in McDonald's franchises.

The court also rejected a rather confused assertion by the IRS that, since an intangible asset is amortizable under Sec. 167 only if it is separate and distinct from goodwill, a similar principal should apply to limit amortization deductions under Sec. 1253. The court disagreed, noting that the specific provision for amortizing franchises, trademarks and trade name under Sec. 1253(d)(2) is not overridden by the more general rules for amortizing intangibles under Sec. 167.

The Tax Court concluded that the purchase price of the McDonald's franchises should be determined by subtracting the value of the tangible assets (and minimal going concern value) from the total purchase price. The amount so determined was properly amortizable under Sec. 1253(d)(2)(A).

Canterbury is an important decision for taxpayers seeking to amortize the cost paid for valuable franchise rights under Sec. 1253(d). Equally important is that court reached its conclusion even after acknowledging that a significant amount of goodwill was acquired by the taxpayers, but because that goodwill was inherent in the McDonald's franchises acquired by taxpayers, the franchises were nevertheless amortizable under Sec. 1253(d)(2).

Taxpayers must be cautioned, however, that the unique features of a McDonald's franchise may render Canterbury distinguishable from other cases involving franchises; the importance of such a distinction remains to be seen. It should also be noted that the extension of the amortization period in Sec. 1253(d) from 10 years to 25 years for most franchise rights acquired after Oct. 2, 1989 limits the importance of Sec. 1253 generally and Canterbury in particular.