Franchise rights are considered a capital asset in a business. Franchise rights are the rights to use a specific name or business method. Franchise rights have a specific cost and usually are purchased for a specific time period. For example, you might purchase the right to a franchise food operation called XYZ Chicken. The cost of the franchise might be $100,000 and the franchise right might be written for a period of five years. The IRS allows the amortization of this cost based on the life of the agreement. In this case, the business could amortize the cost over five years at $20,000 per year. There are specific guidelines that you must follow to deduct this type of amortization expense on your income taxes.
Capital Asset Defined
A capital asset is a type of expenditure that must be amortized over a specific time period. Usually capital expenses include major purchases like equipment, real estate or franchise rights. Capital assets are generally expenses that are long-term assets that can’t be easily sold by a business. The IRS provides guidelines for the deduction of the cost of capital assets.
When a franchise right is purchased, it is shown in the long-term asset section of the balance sheet. Long-term assets are items that have a life of longer than one year, such as equipment or real estate. Since the expense is initially shown in the balance sheet, the cost is not directly deducted on the profit and loss statement. Instead, an accounting entry is made for the tax year that allocates a percentage of the cost of the asset as a depreciation or amortization expense. For example, the accounting entry for a franchise right that cost $50,000 for five years would be: debit franchise amortization expense on the profit and loss statement for $10,000, and credit amortization allowance on the balance sheet for $10,000.
Amortization expenses should be reported on IRS Form 4562, which is for depreciation and amortization expenses. The amortization expense total on this form is then transferred to the schedule of income and expenses, which is Schedule C of the individual tax return. If the business is a corporation, the depreciation expense is transferred to the corporate return, which is IRS Form 1120. To be deductible, the franchise right must have a specific cost, be necessary in the operation of the business, and be written for a specific time period.
You should consult with a tax professional regarding the amortization of franchise rights, because the cost can be significant and capital assets must be amortized based on a specific set of rules. If an amortization expense is improperly taken, the penalties and interest could be substantial for a business.