Franchise accounting guide How does percentage rent work, and where is the breakpoint?

What is the difference between a natural and an artificial breakpoint?

A natural breakpoint is the sales level at which the percentage of sales would equal the base rent — base rent divided by the percentage rate. Below it the tenant pays base rent only; above it, the tenant pays the percentage on every dollar of sales over the breakpoint as well^[1]. An artificial breakpoint is simply a figure the lease names, higher or lower than the natural one, usually because base rent was negotiated separately from the percentage.

How do you calculate it?

Annual base rent                     96,000.00
Percentage rate                           6%
Natural breakpoint   96,000 ÷ 6% = 1,600,000.00

Annual gross sales (as the lease defines them)   1,750,000.00
Sales over the breakpoint                          150,000.00
Percentage rent      150,000 × 6%  =   9,000.00

The store pays its $96,000 of base rent through the year and $9,000 of percentage rent on top. Had sales been $1,590,000, it would owe no percentage rent at all — which is why the breakpoint, not the rate, is the number to watch.

Why does the breakpoint move?

Because base rent does. A lease with 5% annual escalations takes base rent from $96,000 to $100,800 in year two and $105,840 in year three. The natural breakpoint follows it: $1,600,000, then $1,680,000, then $1,764,000. A tracker that stored “$1.6M breakpoint” on the day the lease was signed is wrong from the first escalation. The breakpoint has to be recomputed from base rent each lease year — and where a lease states an artificial breakpoint with its own schedule, that schedule governs instead.

Is it measured monthly or annually?

Most leases measure percentage rent over the lease year and settle it with a statement of annual sales, sometimes with monthly or quarterly estimated payments along the way. Where payments are monthly against one-twelfth of the annual breakpoint, a strong summer can trigger payments that a weak winter later reverses at the annual true-up. Read the lease for three things: the measurement period, whether the breakpoint is cumulative across it, and when the true-up is due.

What counts as sales for percentage rent?

The lease defines it, and the definition is rarely the same as your franchise agreement’s royalty basis. Common exclusions are sales tax, refunds, employee meals, gift cards until redeemed, and sometimes delivery or online orders not fulfilled from the premises. Common inclusions that surprise tenants are catering and sales from a kiosk or patio the lease counts as part of the premises. Keep the lease’s definition next to the franchise agreement’s — they are two different numbers from the same register, and franchisee counsel routinely negotiate exclusions into it before signing^[3].

How is percentage rent accounted for?

Under ASC 842 a payment that depends on the tenant’s sales is a variable lease payment. It is not included in the lease liability or right-of-use asset; it is recognised as expense in the period the obligation is incurred^[2]. In practice, once year-to-date sales make it probable the breakpoint will be crossed, accrue percentage rent each period on the sales above the pro-rated breakpoint, rather than booking the whole amount when the annual statement is sent.

Read more on what does go into the liability in ASC 842 for franchise leases.

What does the landlord ask for?

• A statement of gross sales, as the lease defines them, for each period and for the lease year — often certified by an officer or an accountant.
• Access to the records behind it, under an audit clause; many leases shift the audit cost to the tenant if sales were understated beyond a threshold.
• Payment of the percentage rent, and of any true-up, by the lease’s deadline.