Traditionally, nexus for state income tax liability has required some type of physical presence or continuous contacts by the franchisor/distributor with a particular state. With the advent of taxing authorities asserting that all that is needed is “economic nexus,” franchisors are now increasingly exposed to income tax liability based upon royalty revenue they receive regardless of its bricks and mortar in the state.1 Furthermore, budget deficits in many states cause many states to become increasingly aggressive in the assessment and collection of taxes from nonresident franchisors. After all, it is more politically expedient to raise revenue from nonresident businesses than to impose new taxes on resident businesses. Considering this, franchisors should assume that they owe taxes not only in their home state but also in any state where they have franchisees, regardless of whether they have a physical presence in the state. Only through a proactive approach can tax liabilities be quantified and minimized. These include:

1. Conduct an overall review of current operations and relationships. A careful analysis should be conducted to determine the exposures that exist, returns that have been filed, states in which you have not only paid taxes, but also those with franchisees where you have not. This review should consider not only locations, but also the applicable law and franchisor activities that are conducted in a state.

2.Take action to limit risk. Examine where you have franchisees and have not filed a return even if you’ve received advice in the past that it was not necessary. As more states continue to adopt an economic nexus approach, it may only be a matter of time before these states begin to assert liabilities that were thought unlikely before the advent of the assertion of economic nexus theories. This review should also be conducted by foreign franchisors and distributors that do business in the U.S. For example, a Canadian franchisor may not be required to file a U.S. federal income tax return if they do not have enough physical presence in the U.S., but such franchisors may still be required to file returns and pay taxes to the states where they have franchisees if their franchisees are located in states where economic nexus is the law.

Consider also whether the states where franchisees are located have unfavorable law or are aggressive in asserting liability on out of state franchisors. The danger is obviously greater with a state where the applicable law is favorable to the state and where the state has indicated a willingness to use it. If so, the problem is not going to go away by ignoring it. It will only get worse. It is important to remember that if there is no return filed, the statute of limitations will typically never run. If the state involved does assert liability for income taxes at a later date, the assessment will also usually require the payment of interest and penalties for not filing the required returns. These assessments can quickly become significant enough that the cost of even a valid challenge to the existence of sufficient nexus and the application of the tax will force a franchisor to consider an unfavorable settlement.

3. Determine if there are any voluntary compliance programs and examine total tax exposure in all states. A number of states have programs to encourage voluntary compliance with tax laws. While these programs vary from state to state, they will often include provisions that limit how far back the state will assert liability and that reduce or minimize penalties and interest. This may limit exposure. Conversely, the examination should also determine if there are any opportunities that could come from such a filing. For example, while the ability to apportion income and to claim credit for taxes paid to other states will vary depending upon the states involved, a franchisor in a high tax state may be able may be able to file amended returns reducing their taxation in their home state by apportioning income to the remote state. This may reduce or even eliminate the impact of the taxes paid to the franchisee’s state.

4. Consider revisions to franchise agreements. An obvious partial solution is to include a provision that has the effect of passing the state income tax back to the franchisees in that state on a pro-rata basis, either through a tax indemnity or a “gross up” provision. This solution is not, however, without its problems. First, franchise agreements are long term agreements and it will often take 10 years or longer to have all contracts revised.2 In addition, the gross up of the payments made to the franchisor increases the revenue received by the franchisor thereby further increasing the taxes due. Such a provision would also require disclosure of the franchisor’s tax return that would not normally be available to the franchisee. Finally, but hardly less important, there is the potential for not only impaired goodwill with the franchise community but also adverse impacts upon their profitability as well. While the latter effect is not completely unfair considering that not all states have these tax regimes, that may be of little solace to the franchisee who is likely to think that this is nothing more than shifting the franchisor’s tax to them.

The evolution of the law and the need for states to increase revenue is likely to increase the risk associated with not proactively addressing these potential liabilities. The exposure, if not proactively addressed, will probably increase. To assure that all contingent liabilities that could impair the franchisor’s balance sheet are addressed (and potentially it’s marketability if a sale is ever considered), the sooner the issue is addressed the more manageable it is. Only a thorough examination of the facts and law of the states involved will limit risks that could affect the profitability of the company.