IRC 1253: Transfers of Franchises, Trademarks, and Trade Names

Internal Revenue Code (IRC) Section 1253 establishes the tax rules for transactions involving the transfer of franchises, trademarks, and trade names. This regulation determines whether the transfer is treated as a sale of a capital asset or as a license, which significantly impacts the tax obligations of both the seller and the buyer. The core of this determination lies in the level of control the seller, or transferor, maintains over the asset after the transaction is complete.

If the transferor retains substantial control, the tax treatment differs markedly from a situation where control is fully relinquished. These rules apply not only to the initial transfer but also to any subsequent renewals of the franchise, trademark, or trade name.

The Significant Power Test

The “significant power, right, or continuing interest” test is a set of criteria used to determine if the transferor of a franchise, trademark, or trade name has retained too much control for the transaction to be considered a sale for tax purposes. If the transferor keeps one or more of these specified powers, the law treats the transfer as a license. The term “franchise” is broadly defined to include any agreement that grants the right to distribute, sell, or provide goods, services, or facilities within a specific area.

The statute explicitly lists several rights that qualify as a significant power, including:

• The power to disapprove any assignment of the transferred interest to another party.
• The right for the transferor to terminate the agreement at will.
• The right to prescribe the standards of quality for products and services, as well as for the equipment and facilities used to promote them.
• The right to require the transferee to sell or advertise only the transferor’s products or services.
• A requirement for the transferee to purchase a substantial portion of their supplies and equipment from the transferor.
• The right to receive payments that are contingent on the productivity, use, or disposition of the asset, if these payments make up a substantial element of the transfer agreement.

Tax Treatment for the Transferor

If the transfer agreement includes the retention of any significant power, right, or continuing interest, the transfer is not treated as a sale or exchange of a capital asset. Any payments the transferor receives are classified as ordinary income, which is taxed at higher rates than long-term capital gains.

A distinction exists between contingent and non-contingent payments. Any payments received by the transferor that are contingent on the productivity, use, or disposition of the franchise, trademark, or trade name are always treated as ordinary income. This rule applies regardless of whether the transferor retained any other significant powers.

For non-contingent payments, such as a large upfront lump-sum payment, the tax treatment depends on the significant power test. If a significant power is retained, that lump-sum payment is recognized as ordinary income. If no significant power is retained, the transferor may be able to treat the transaction as the sale of a capital asset, potentially resulting in a lower tax liability through capital gains treatment.

Consider a franchisor who sells a new franchise location. The agreement requires the franchisee to pay a $100,000 upfront fee and ongoing monthly payments equal to 5% of gross sales. The franchisor retains the right to approve the quality of all products sold. Because the franchisor retained a significant power, the initial $100,000 fee is taxed as ordinary income. The ongoing 5% payments, being contingent on productivity, are also taxed as ordinary income.

Tax Treatment for the Transferee

For the transferee, or the buyer, the tax treatment focuses on how they can recover the cost of acquiring the franchise, trademark, or trade name. The rules provide different methods for deducting payments, depending on whether they are contingent or non-contingent.

Contingent payments that are based on the productivity, use, or disposition of the asset receive favorable tax treatment for the transferee. These amounts, often paid as ongoing royalties, can be deducted in the year they are paid or incurred as a business expense under IRC Section 162. This allows for an immediate write-off of these operational costs.

Non-contingent payments, such as a fixed upfront fee, are handled differently. These payments are not immediately deductible. Instead, the amount paid is treated as a capital expenditure and must be capitalized. The transferee then recovers this cost over time through amortization.

Under IRC Section 197, intangible assets like franchises, trademarks, and trade names are amortized on a straight-line basis over a 15-year period. This applies to the non-contingent portion of the acquisition cost. For example, if a franchisee pays a $300,000 lump-sum fee for a franchise, they cannot deduct the full amount in the year of purchase. Instead, they can deduct $20,000 per year ($300,000 / 15 years) for 15 years.