One of the main elements of negotiating a leased space is the cost associated with the build out of the space. Tenants generally require some level of customization of the space for their business purpose. The construction allowance seems to be a straightforward mechanism that allows a landlord to improve their property by simply reimbursing the new lessee with a pre-negotiated amount. In exchange the lessee generally has significant control in matching the finishes to their needs while also limiting the size of their investment in their temporary home.
Under the most basic read of the Internal Revenue Code the payment from the landlord is taxable income to the lessee. This creates an obvious dilemma for the lessee. Internal Revenue Code Section 110 was created to address this inequity. The provision establishes the parameters of a tax-free construction allowance.
- The lease is limited to 15 years or less.
- The improvements are for nonresidential real property.
- The improvements must be part of a retail space (includes services to the public).
- The landlord owns the improvements.
- The provision will not apply to Section 1245 property (tangible personal property).
If the construction allowance violates any of these provisions then the payment will likely be taxable income at least in some portion. There are some planning steps that can help solidify favorable treatment under this provision and it all starts with adding the correct language in the lease agreement and following proper procedures for payment. From there proper documentation of the expenditures should be maintained and the tax return should have the proper disclosures. If some portion of the construction allowance will still be used for personal property then the terms of the lease should be adjusted to ensure that the tax consequences match the intended results.
Franchising has become a common path in a variety of industries. It can be a tremendous growth engine for the originators of a concept and in turn provides a platform for someone to launch a business. It is not uncommon for a life-long employee to become consumed with the desire to “be their own boss” and a franchise is often the answer to: “But, what?”
Franchisors spend significant time and dollars road testing and documenting their concept, formulas and processes. A qualified and experienced franchisor does an excellent job of eliminating many of the pain points so the process of launching a business is seemingly automated.
However, there is a critical “Must” for all prospective franchisees in considering a business. The most important thing a prospective franchisee MUST acknowledge is that they are participating in a sales process of the franchisor and its representatives.
Franchisors genuinely believe they have THE best concept and they need partners to help grow it. In exchange for the right to use their concept a franchisor is typically compensated by a large upfront fee and a royalty off the top line revenue (generally 5%-8%). Their objective is to open as many “units” as possible. The prospective franchisee’s objective is to launch a profitable business. These are two very different objectives.
Let’s look at a restaurant franchise as an example. The restaurant business is built on strict margins. It is becoming increasingly more difficult to keep food costs at or below 30%. There are also increasing challenges in the labor market with the introduction of the Affordable Care Act and the vigorous debate on raising the minimum wage. If we conservatively assume food and labor costs will consume 65% of the sales while occupancy and overhead will consume 20%, you’re left with 15% of sales. Is this concept worth splitting the 15% operating profit with the franchisor? Well, maybe……..but wait, you haven’t paid the bank yet which will come from your half and the franchisor’s half is guaranteed because it comes off the top – immediately. Oh yeah, you also personally guaranteed the bank debt and the lease. So you have a 50/50 partnership with all the risk exposure and operating challenges on your half. Also if sales dip, the fixed costs will dip into your percentage points. To be fair – if sales excel, additional percentage points will tip your way. In the end the franchisor must have a strong value proposition.
I’ve seen both good and bad franchisors. I’ve also see good and bad franchisees. It takes both. However, the onus is on you – the franchisee – to thoroughly vet the concept and franchisor. From there it is wise to have advisors outside of the franchisor to help you evaluate the projected numbers and the terms of the various legal agreements especially on real estate matters. Frankly, you need an outside advisor that’s going to question the whole idea in the first place. There are so many intangibles to discuss about business ownership that go beyond cost, risk or strength of concept. It is far better to spend some consulting dollars on the front end than being locked into a lofty sales goal with an expensive lease in an industry you know very little about. Maybe a vacation is all you really need.