Can Franchise Rights be Exchanged?
Since becoming law in 1921, the rationale for the inclusion of tax deferred exchanges in the IRS code, has been that a taxpayer who is vested with an asset and who receives in exchange other like-kind assets, and no cash, there is a continuity of holding the same or similar assets. Since the same kind of assets were sold and bought and the taxpayer pocketed no cash, the transaction isn't seen as a taxable event. The gain on the sale of the first assets, the relinquished property , is deferred until the acquired like-kind assets, the replacement property , are sold without a further exchange.
Upon the passage of the Tax Cuts and Jobs Act (TCJA) in 2017, the types of assets qualifying for tax deferral through an exchange changed dramatically. Tax deferral through 1031 exchanges would only be allowed for what is considered real property (land, buildings, etc.) and not for personal property (heavy equipment, cars, franchises. Therefore, since the passage of the TCJA, the actual franchise rights no longer qualify for a like kind exchange to defer taxes on gains. However, should the investor own the underlying real property where the Franchise resides the investor still could qualify for an exchange on the underlying land/building.
What Qualifies for Tax Deferral upon the Sale of a Franchise?
Perhaps the most common inquiries around franchise exchanges are those that involve fast food restaurants. An owner might have one or more franchise locations that have greatly increased in value over time, value that the owner would like to parlay into additional restaurants. The exchange of such a business was formerly a more straightforward matter because the IRS regarded the business as a whole entity that included the value of any underlying assets. This changed shortly before 1991's exchange regulations, and now the IRS requires that each underlying asset be separated and valued individually.
For owners/investors of franchises this means that the value of the franchise rights are separate from the value of land, buildings and furniture, fixtures and equipment (FF&E). A restaurant franchise valued at $300,000 for the franchise rights and $750,000 for the land/building can separate the sale of the land/building from the sale of the franchise rights. The land/building would then qualify for a like-kind exchange into land/building for a new franchise or a multitude of other real property deemed like-kind such as a multi-family rental building or farmland.
It's worth noting that any value associated with goodwill, including trademarks and trade names, is not capable of being exchanged, because the regulations state that goodwill is "inherently unique and inseparable from the business." For this reason, sellers of businesses may wish to minimize the value of the goodwill and increase another component asset of the sale which will be capable of receiving like-kind exchange treatment. Inventory and cash-on-hand are also not part of a franchise exchange since, unlike equipment, these assets are not held for use in a business or trade.
Retaining the Services of a Qualified Intermediary
A qualified intermediary (QI) is necessary for most exchanges in which the relinquished assets are sold to a buyer and the replacement assets are being acquired from a seller, who is not the same as the buyer of the relinquished assets. The taxpayer essentially sells the relinquished assets to the QI, who in turn sells them to the buyer. Similarly, the taxpayer purchases the replacement assets from the QI, who acquires those assets from the seller. In effect, the taxpayer completes an exchange with the QI. Selecting the correct QI is a decision that should not be taken lightly. Read on to learn more about the considerations for choosing the right QI for your transaction.