U.S. Supreme Court Action Signals Tax Risks for Franchisors

October 31, 2011

U.S. Supreme Court Action Signals Tax Risks for Franchisors

What Happened? On October 3, the U. S. Supreme Court refused to hear an Iowa Supreme Court decision that found the franchisor, KFC, subject to Iowa's corporate income tax solely because KFC received royalties from franchisees in Iowa.

What Does It Mean? The ruling in Iowa now stands as law for that state. The full impact of the case may not be known for sometime. However, most states are in poor financial health and are looking for additional revenue sources. Many other states are therefore likely to follow suit and tax out-state franchisors on royalties they receive from franchisees located in their states.

What to Do Now?

  • Franchisors should consult with their tax advisors, even if they do not have franchisees in Iowa. Other states may be likely to take aggressive action in light of the Iowa Supreme Court ruling. In some cases, franchisors may decide to voluntarily contact the state taxing authority in an effort to avoid potential exposure to interest and penalties. In many cases, a taxpayer can avoid penalties and interest if it reports itself to the state taxing authority and agrees to file tax returns in the future.
  • Franchisors should review their corporate structure with their tax advisors, because the impact of this decision may be affected by the franchisor's corporate structure and the place where its owners reside.
  • From a franchise law standpoint, although many franchise agreements have not traditionally included a "tax gross up" provision, there is a trend among franchisors to include such provisions in their future agreements, and we have been including them in many of our new and updated franchise agreements. A "tax gross up" provision requires the franchisee to reimburse the franchisor if it has to pay higher taxes on royalties. Of course, franchisors can expect sophisticated franchisees to be aware of this issue as well, and some may be reluctant to agree to it.

The various state tax laws are complicated and are not uniform. There is no "one size fits all" answer, and this is an issue that franchisors cannot ignore. We plan to update new franchise agreements to include a "tax gross up" provision and would be happy to discuss this with our franchisor clients and their tax advisors. The case is KFC Corporation v. Iowa Dept. of Revenue (Iowa Dec. 30, 2010), cert. denied by the United States Supreme Court on Oct. 3, 2011.

Courts continue to Weigh Existence of Employment Relationship in the Franchise and Distribution Context

Courts continue to weigh whether a franchise or distribution relationship can establish an employment relationship. Several courts recently issued decisions relating to a franchisor's liability as an employer. These decisions can have significant impacts on taxes, labor laws, negligence liability, and a host of other issues. The following cases confirm that the issue is rarely clear.

Massachusetts: The Massachusetts Supreme Judicial Court answered a question certified from a federal court regarding damages for the misclassification of a franchisee. In 2010, a federal court held that janitorial franchisees were not independent contractors, but employees of the franchisor. But, because the federal court was unsure as to what damages were recoverable by the franchisee for the misclassification, it certified damages questions to the Massachusetts Supreme Judicial Court.

The Massachusetts Supreme Judicial Court concluded that "wages" under Massachusetts' Wage Act include franchise fees and insurance premiums, and held that damages for the misclassification of employees as franchisees should refund these amounts, and also include attorneys' fees and possibly treble damages. Also, the court held that the franchisor could not pass on the workers' compensation and insurance costs to the franchisee because they protected the franchisor. The court also concluded that chargebacks to the franchisee for unpaid customer bills violated the Act due to the failure to pay an employee within the time required by statute.

Importantly, the Massachusetts Supreme Judicial Court did not resolve whether the federal court's employment conclusion was correct, but restricted its decision to focus on the damages. The franchise relationship at issue is somewhat unique because of the franchisor's direct role with the collection of payment for the services. The court's conclusion may also reflect differential treatment where the franchisee is an individual, rather than an entity. The case is Awuah v. Coverall N. Am., Inc. (Mass. Aug. 31, 2011).

Mississippi: A Mississippi district court denied summary judgment to a master franchisor because there was a question whether it had an employment relationship with its franchisee. As a result, the court held that the question would have to be resolved by a jury. The plaintiff alleges that the franchisor is liable for the negligence of the franchisee under the theory of respondeat superior. In considering whether summary judgment should be granted, the court evaluated ten factors identified by the Mississippi Supreme Court for distinguishing between an employee and independent contractor for purposes of holding an employer liable for negligent acts. As it generally does, the issue came down to control, particularly the franchisor's right to control the details or means of the franchisee's work.

In evaluating the ten factors, the court reviewed the franchise agreement, which suggested that the parties intended to create an independent-contractor relationship. Unfortunately, that alone did not resolve the question. In weighing these factors, the court directed that the conduct of the parties, as well as the written agreements, should be evaluated. The court's evaluation of the ten factors resulted in some indication of an employer-employee relationship, including the franchisor's ability to terminate the contract at will, the franchisor's approval of the location of performance, indications that the franchisor controlled the premises, and control over the kind and character of work to be performed. The case is Hayes v. Enmon Enterprises, LLC, et al. (S.D. Miss. June 22, 2011).

Georgia: In a similar case, a Georgia court concluded that no employment relationship existed in a three-tiered franchise situation. The Georgia Court of Appeals held that a unit franchisee was not an employee of the master franchisor under the Massachusetts Independent Contractor Statute. The court applied the statute's three prong test to examine the three-layer franchise arrangement and found that the unit franchisee's business was independent from the master franchisor's operations, who only had a franchise agreement with the regional franchisee. The case is Jan-Pro Franchising Int'l, Inc. v. Depianti (Ga. Ct. App. June 23, 2011).

Ohio: A federal court in Ohio granted a franchisor's motion to dismiss a case filed by female employees against Domino's and its franchisee alleging employment discrimination under Title VII and Ohio law. In applying the test adopted by the Sixth Circuit for determining whether a franchisor will be considered the employer of a franchisee's employees, the court found no indication that the franchisor and franchisee operated as a single employer. Similarly, the court concluded that no employment relationship existed under Ohio law and the franchisor was not vicariously liable from a principal-agent relationship. The case is Bricker v. R&A Pizza, Inc. (S.D. Ohio April 8, 2011).

In another federal case in Ohio, the court granted summary judgment in favor of Papa John's in a case concerning the Americans with Disabilities Act. The court applied the Sixth Circuit's test for determining whether a franchisor is the employer of a franchisee's employees. The court concluded that no employment relationship existed between the franchisor and employees of the franchisees. The court considered that the businesses were separate and distinct, including that the franchisor did not have control over the day-to-day activities of the franchisees. The case is Howell v. Papa John's Int'l, et al. (N.D. Ohio Aug. 16, 2011).

Texas: In Texas, a case was recently filed by the widow of a pizza delivery man against Domino's and its franchisee. The case, concerning an attack during a pizza delivery, alleges negligence related to safety procedures and delivery to an unsafe neighborhood. Certainly, the franchisor's role in relation to the franchisee's pizza delivery employee will be an important question in the case. The case was filed in July in Tarrant County, Texas.

Virginia: The Virginia Attorney General recently released an opinion regarding Virginia's workers misclassification act. The opinion stated that, in general, the test under Virginia law would not find an employment relationship between a franchisor and franchisee.

The risks involved with the existence of an employment relationship can have significant effects on a multitude of issues from worker's compensation to negligence liability. This determination can be critical when the question is who is responsible for payment of worker's compensation and employment-related taxes, especially in the current economic climate. As shown by these examples, the issue is far from settled, and different jurisdictions often reach different decisions based on the facts of each case. Notably, many of these cases arise for cleaning business franchisors who often agree to find business for their franchisees.

To minimize the chances of being considered an employer, it is important to have an attorney familiar with the current law on employment relationships review your franchise and distribution agreements and practices. Discussions with your attorney may include: how the business relationship should be described in any agreement, how the relationship should be structured, whether franchisors should require their franchisees to be incorporated entities, and the importance of the description of the franchisor's business.

The Eighth Circuit Holds that a Distribution Agreement is Perpetual

The Eighth Circuit, applying Nevada law, held that a distribution agreement was for a perpetual duration, and not terminable at will. Although the term "perpetual" was nowhere in the agreement, the contract's "Term" provision provided that it "shall remain in effect until terminated" in one of two situations: (1) termination by mutual consent or (2) termination by default. The court also reinstated the jury's verdict and award for estimated future lost profits. The manufacturer was awarded the damages on its claim for breach of the implied covenant of good faith and fair dealing because the distributor had failed to carry out the manufacturer's brand repositioning by distributing certain products. The case is Southern Wine and Spirits of Nevada v. Mountain Valley Spring Co., LLC (8th Cir. July 19, 2011).

Franchisee Association has Standing to Pursue Claims

A federal court in Connecticut found that an association of more than 170 Edible Arrangement franchisees has associational standing to sue Edible Arrangements for violation of franchise agreements. The franchisee association brought claims against the franchisor concerning undisclosed fees, mandatory use of an ordering system, and violation of federal regulations for the failure to disclose the franchisor's relationship with affiliates that it required its franchisees to do business with. Although the franchisor argued that there were at least three versions of the franchise agreement at issue and many different disclosure documents, the court found that all of the agreements gave the franchisor a right to charge a fee, which was the focus of the association's complaint. The court also found that the arbitration provision in the individual members' franchise agreements did not require a finding that the association lacked standing. The court left open reconsidering the association's ability to maintain standing as the litigation proceeded, and the franchisor has filed a request to move the case to arbitration. The case is EA Indep. Franchisee Assoc., LLC v. Edible Arrangements Int'l, Inc. (D.Conn. July 19, 2011).

Federal Court Finds that Beer Distribution Relationship is Not a Missouri Franchise

A federal court in Missouri held that a distribution relationship between a beer distributor and importer seller was not a franchise under the Missouri franchise law. The court granted summary judgment for the supplier and against the distributor where the distributor claimed that the seller violated the Missouri franchise law by unilaterally terminating the distribution relationship.

The court considered whether, under Missouri law, the criteria for a liquor franchise also includes the requirements of the general franchise definition in the statute. The court concluded that a liquor franchise requires both the specific criteria as well as the general franchise requirements under Missouri law. Applying these requirements, the court found that the distribution relationship at issue was not a franchise under Missouri law because (1) the relationship involved no name or trademark license and (2) there was a lack of community of interest, both of which are requirements under the general franchise statute. The case is Missouri Beverage Co., Inc. v. Shelton Brothers, Inc. (W.D. Mo. June 17, 2011).

Greensfelder News

John Baer was named as the "Chicago Franchise Lawyer of the Year" and Leonard Vines was named as the "St. Louis Franchise Lawyer of the Year" by Best Lawyers in America. Only one lawyer in each practice area of each major U. S. city is chosen for the award. According to the Best Lawyer's website, those who were selected received particularly high ratings from most of their peers. In some cases, they also received particularly effusive comments from some of those same peers. The selected lawyers have earned a high level of respect among other leading lawyers in the same communities and the same practice areas for their abilities, their professionalism, and their integrity.

John Baer, Beata Krakus, and Leonard Vines were selected for the International Who's Who of Franchise Lawyers, as well as the prestigious Chambers USA, which ranks leading law firms and attorney through in-depth, client focused research.

John Baer, Chris Feldmeir, Karen Johnson, Beata Krakus, Abby Risner, and Leonard Vines attended the American Bar Association's 2011 Annual Forum on Franchising in Baltimore, Maryland. The conference held annually focuses on timely franchising and distribution issues. Beata Krakus spoke at this year's conference on the use of consultants and paralegals in franchising.

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