Franchise Lawyer Blog

We have previously written about state efforts to obtain franchisor financial information, specifically efforts by the New York State Department of Taxation and Finance to require annual information returns from franchisors. The purpose of this would be to determine if franchisees are not providing completely accurate information for the purpose of fixing sales taxes and state income taxes.

A recent piece in the Law Journal Newsletters Franchising Business & Law Alert, written by Dirk Giseburt, Rochelle Spandorf and Jaymee Castrillo, reports that the State of California has now initiated efforts through its California Franchise Tax Board (FTB) to require California franchisees to begin withholding 7% of all lease and royalty payments to out-of-state franchisors that exceed $1500 per calendar year. The stated goal is to require out-of-state franchisors to become qualified to do business in the State of California, which carries with it the obligation to file State income tax returns. Apparently, some organizations, such as the IFA, are questioning the FTB's authority to impose such a withholding requirement. The inquiry into applicability in a particular instance would focus on two theories, first, that royalties and the like represent California source income; and second that a franchisor has established a business situs in California when its intangible assets are used in a California business, in this case, the asset being the franchise license.

As in New York, these fledgling regulations are still being tested. Franchisors and franchisees are well advised to refer to their accountants and franchise counsel for an up to date assessment of current applications, so that they are continually making informed decisions as to whether or not to provide different types of reporting under consideration.

New York's Department of Taxation and Finance has extended the original September 21 compliance deadline and reportedly is changing the rule to make it less burdensome. The available 90 day extensions now extend until December 20, 2009.

New York State's 2009-2010 budget contains a new law which is intended to make it less difficult for the State's Department of Taxation and Finance to determine if franchisees of franchised chains are cheating on their taxes. This law, which received scant attention upon its creation, has recently attracted the attention of a number of franchisor trade groups as well as publications advocating franchisee and franchisor interests.

The Albany Business Review reports that the International Franchise Association (IFA) has written to the State Department of Taxation and Finance asking it to delay the enforcement of the new law. The law requires franchisors to report to the State what has been reported to them in terms of annual transactional information, including gross revenues on sales of goods and services and sales to franchisees by suppliers recommended by the franchisor.

The franchisee website BlueMauMau reports that the law's intent is to give New York the right to demand from the franchisor the gross revenue figures gathered about a franchisee. BlueMauMau quotes the IFA's letter as stating that this requirement is the first of its kind in the nation. The IFA is requesting that enforcement be stayed from the official effective date of September 20 to December 31, 2009.

Increased concern about the requirements of the law has caused it to appear in discussions on other franchise websites, such as QSR WEB, which voices the concerns of the quick service restaurant industry.

The official reason for the requested delay is that franchisors will not have time to collect the submitted information and submit it to the State in the 20 days outlined in the law. However, the real underlying concern about the law is that there are many reasons, some legitimate and some not, why the gross sales figures presented on tax returns might differ from the figures provided to the franchisor. But there will invariably be differences and the concern is that any discrepancy will become an automatic red flag for an audit, as well as giving rise to possible franchisor claims of underreporting.

Most franchised businesses are small businesses, by some definition. Financing a small business has always been a difficult proposition, particularly a start-up small business. And that has never been more true than today, when frozen credit markets, uncertain loan standards and skittish loan officers have made it virtually impossible for a small business to obtain credit.

In the past, the U.S. Small Business Administration ("SBA") has been able to lend assistance in this area. The SBA guaranties qualified loans from approved lenders, making it easier for banks to extend credit to certain franchisees. The SBA has actively engaged itself in the franchising industry with the creation of The SBA Franchise Registry. The Franchise Registry, found at a website managed by FRANdata, describes itself as "a national online listing of franchise systems whose franchisees receive expedited loan process when applying for financial assistance from the U.S. Small Business Administation (SBA)." The SBA preapproves the franchise agreement and, effectively, the franchise system. The website observes that membership on the Registry is not a prerequisite for obtaining an SBA loan, but then it notes that some SBA lenders will not process a loan for a franchise system that is not represented on the Registry.

The SBA requirements that have developed over the years as being necessary for a system to obtain qualification have frequently been a source of controversy. Recent posts on the Listserv for the ABA Forum on Franchising have discussed an SBA requirement that the SBA will not approve a loan in a system where franchisees are subject to Electronic Funds Transfers (EFT) by the franchisor, because this does not leave the franchisee with sufficient control over its own business to qualify as an independent small business. Naturally, this has given rise to cries of outrage from franchisor counsel that preventing the use of EFT and similar electronic/internet monitoring devices strips the franchisor of necessary protections that are commonly used in this day and age.

A recent email to the ListServ from the IFA commented on that organization's lobbying efforts to gain recognition in Washington that the SBA loan guarantee is frequently the only way a fledgling franchise can obtain financing. The IFA and other franchisor advocates have argued that the rules relating to the loan guarantee programs need to be updated and improved to take into acount frozen lending markets and rapidly developing tools being used within franchise systems, tools which sometimes blur the line between control and independence.

If you are a franchisor interested in facilitating credit for your franchisees, we suggest you look into the SBA program, at the website noted above. If you are a potential franchisee, we suggest you go to the actual Franchise Registry and see if the system you are interested in is represented there.

We will keep abreast of developments in this area and provide further advice down the road.

Occasionally a prospective client will come into our office and describe a desire to exponentially expand their business without having to deal with the expense and bother of franchise registration. What they usually have in mind is some sort of licensing arrangement. In some cases they will have already set up one or more outposts of their business, operating under their name, or they have negotiated with individuals and promised them the right to operate a location under their valuable brand name.
Our answer is invariably the same. If you are attempting to set up a business and it occurs to you that you want to avoid being a franchise, it is probably too late. You already are a franchise. This is because there are simple elements to the definition of a franchise that are almost unavoidable in establishing an expandable and replicable business model.
Generally speaking, a franchise exists when the owner licenses a trademark or tradename for use in connection with a business system in exchange for a fee for that right. You can look at the FAQ's on our website for a more detailed discussion of those concepts. Most states utilize this "three prong test." The rule in New York is even broader, requiring only two of the three prongs. A franchise exists in New York when there exists either (i) a marketing plan or system and a fee; or (ii) the use of a trademark and a fee.
The client who wishes to replicate their business model will invariably be licensing the use of a brand name, usually a registered trademark. They will be charging a fee, in one form or another. Changing the nature or manner of the fee doesn't avoid the definition. And the client will typically have a business sytem or model that they will want to see utilized in order to establish control over the quality of the developed businesses. There is no sensible way to avoid any of these criteria, they are all essential elements of a successful business development plan.
So the discussion inevitably turns to the requirements for franchising: the creation of the Franchise Disclosure Document ("FDD") and, where necessary, registration. We will be discussing both the form of the FDD and the registration requirements in future entries.
In some cases, clients already have one or more operations on the ground and running by the time they get to us. In these cases, the licensor/franchisors are exposed to liabilities created by the federal and state laws on franchising. These previously established branches will be considered to be franchises that have been sold without proper adherence to the state and federal requirements regarding FDD's. The client may be subject to damages for any losses suffered by these operators and may be required to offer rescission of the contract to those operators. In those cases, in order to properly initiate a franchise system, the previously established businesses will have to be negotiated with, in order to extricate the franchisor from the prior agreements and offer those operators an appropriate FDD.