The IRS Office of Chief Counsel has informally ruled (General Legal Advice Memorandum 2014-004; the “GLAM”) that payments made by manufacturers to their franchisees under “facility image upgrade programs” are immediately includible in the taxable income of the franchisees. The franchisees then may obtain an offsetting deduction only through depreciation of the property upgrades, typically over a 15-year period for retailers.
In a recent blog post, we discussed the IRS’s views of the tax treatment of the manufacturer in connection with these types of payments. The IRS held that the manufacturer could deduct the payments immediately. As we observed in the prior post, “Unspoken is the possibility that the IRS would require the construction support payment to be treated as income to the retailer when received. See, e.g., John B. White, Inc. v. Commissioner, 55 T.C. 729 (1971), aff’d per curiam, 458 F.2d 989 (3d Cir. 1972) (incentive payment by car manufacturer to dealer to move to a better neighborhood must be included in dealer’s income).” With its new guidance discussed in this post, the IRS has dropped the other shoe and held that the retailer must include the amount in income immediately.
The GLAM involved various types of payments made by automobile manufacturers to their dealers. The reasoning is not specific to the automotive industry, however, and could apply to any type of manufacturer/franchisee relationship. Indeed, the IRS might apply the Chief Counsel’s views to other franchise relationships as well, e.g., in the hospitality industry, where the franchisor seeks to financially support specific features of its franchisees.
The GLAM discussed facility image upgrade programs in which the automobile manufacturers made payments to franchisees to support a standard brand image for the dealers’ sales and service areas. The improvements could range from cosmetic upgrades to significant structural changes. In some instances, the payments were made only to support “a standard, modernized look for dealership facilities.” In others, the payments also supported upgrades to software and websites and dealer employee training costs.
In some cases, the payments were a percentage of the total upgrade costs. In others, the payments were based on the number of vehicles purchased by the franchisee. In still others, the payments were in part based on the costs of the improvements and in part on the number of vehicles sold by the franchisee.
The GLAM noted that dealers in the industry were reporting the payments differently. Some dealers claimed the payments were nontaxable contributions to capital by a non-shareholder. Others claimed that the payments should be treated as simply reducing the cost of the improvements. Still others treated the payments as a reduction in the purchase price of vehicles acquired from the manufacturer. In all of these cases, the dealers did not include the payments in income. On the other hand, there were “a few” dealers that did include the payments in income.
The Chief Counsel made its views clear that, regardless of the arrangement, the dealer was required to include the support payment in income. The payment was an accession to the dealer’s wealth, which is ordinarily the touchstone for income inclusion. It did not qualify as a non-shareholder capital contribution, ordinarily made to promote the welfare of the community as a whole, because the manufacturer had too direct an interest in the results of the improvement, i.e., the anticipation of being able to sell a greater number of vehicles to the dealer. Although the amount of the payment under some variations was based on the number of vehicles purchased or sold, the payment was not intended to be an adjustment to the purchase price of the vehicles and so could not be treated as a reduction in the dealer’s vehicle costs.
Rather, the Chief Counsel held that the payments were to be included in the costs of construction of the dealership property. As noted previously, these costs would normally be recovered through depreciation deductions over a period of many years. So, for example, instead of being able to exclude a $1,500,000 image upgrade payment from income (apparently the widespread current practice), the dealer could be required to include that payment in income in year 1 and then take offsetting deductions for depreciation of $100,000 in each of years 1 through 15. Although the dealer ultimately would have no net income from the payment, the time-value-of-money consequence to the dealer could be significant.
The impact of the IRS position would apparently be less for those dealers that treated the payments as a reduction in their purchase price of vehicles from the manufacturer. This treatment would result in a greater profit to the dealer on sale of the vehicles, which normally would occur within a year of their purchase, so the benefit of any deferral of tax from this treatment would be minimal. Similarly, to the extent the payment is spent on purchased software upgrades, it might be recovered within three years, and to the extent it is spent on employee training, it normally could be deducted as those costs are incurred.
The GLAM was requested by IRS Division Counsel for the Large Business & International Division, which covers taxpayers with assets greater than $10 million. However, it may very well be applied also by the Small Business & Self-Employed Division, which covers businesses with under $10 million in assets. The GLAM is effectively a go-ahead for IRS agents to raise this issue and may signal enhanced IRS enforcement with regard to these payments.
Taxpayers may still try to argue for income exclusion and, if necessary, take the case to the IRS Appeals Office or to court. As noted above, however, the Chief Counsel relied heavily on John B. White, Inc. v. Commissioner, in which the dealer was required to include in income a relocation payment received from the manufacturer, so taxpayers can expect considerable resistance from the IRS.
Taxpayers that believe that it is unlikely that they will prevail may want to consider whether there is any advantage in requesting a change in accounting method to include the payments in income.  Such voluntary accounting method changes often result in more favorable treatment than changes imposed on audit by the IRS. However, other considerations will also be important, such as whether the statute of limitations has run on assessment of tax for the years in which image upgrade payments were received.
IRS Circular 230 Disclosure: To comply with certain U.S. Treasury regulations, we inform you that, unless expressly stated otherwise, any U.S. federal tax advice contained in this communication, including attachments, was not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding any penalties that may be imposed on such taxpayer by the Internal Revenue Service. In addition, if any such tax advice is used or referred to by other parties in promoting, marketing or recommending any partnership or other entity, investment plan or arrangement, then (i) the advice should be construed as written in connection with the promotion or marketing by others of the transaction(s) or matter(s) addressed in this communication and (ii) the taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor. To the extent that a state taxing authority has adopted rules similar to the relevant provisions of Circular 230, use of any state tax advice contained herein is similarly limited.
 GLAM 2014-004 (April 7, 2014).
 Internal Revenue Code of 1986 (“IRC”) section 168(e)(8), Qualified Retail Improvement Property. This rule has expired but is the subject of pending legislation (S. 2260) that would extend it through 2015.
 The GLAM confirms and gives the explanation for the IRS position as stated in the Internal Revenue Manual, discussed in our prior blog post.
 IRC section 118.
 IRC section 167(f)(1).
 Rev. Rul. 96-62.
 See, e.g., Rev. Proc. 2011-14, Appendix, section 14.14 (change from exclusion of amounts under IRC section 118 to inclusion in gross income).