Editorial

Legal Issues and Tax Considerations for Franchisees

Buying and operating a Franchise is different than most of the other purchase or investment decisions you will make in the course of your lifetime. You are getting a business that you will run using a more-or-less established system, not purchasing something physical like a car or a house. Here are some points to check when considering a franchise.

Franchise Disclosures:

A disclosure form (the franchise Disclosure Document, or FDD) must be provided. It should contain all “material” information on the franchise. Like a securities prospectus, this document is likely to be less than “reader friendly”: dry, legally cautious, financially non-obvious. Read it anyway, very carefully – and look most closely at the list of outlets in the appendix. Verify with actual system operators any claims made; don’t rely on the glossy brochure to give you the whole story.

Disclosures should include:

the franchisor’s business experience
any lawsuits pending against them (many may be from dissatisfied franchisees)
what you get for your money (licenses, system elements, any training and other obligations of the franchisor)
what you are allowed to sell and buy under the system
the franchise fee
other fees
advertising fund and other joint expense contributions you would have to make
the territory you will get, intellectual property status (trademarks, copyrights, patents) the franchisor claims to have
earnings the franchisor says outlets may obtain (many don’t provide this). Note: income projections your franchisor may provide are based on the efforts of others, not what you will be able to do in the location you have chosen.
contracts you’d have to sign
public figures who endorse the system
cancellation and renewal rights you’d have (if any, beyond the “good cause” requirement for cancellation built into the statute)
financials of the franchisor

Other items may be included, but these are essential.

When read carefully, the FDD should help you determine whether you fit the franchise offered. Use it to identify some of the major business issues your new business may face when dealing with your franchisor, area agent, or master franchisee, as well as your legal relationships with the franchisor, your employees, any partners you are allowed for business operations, and any vendors (contractors, equipment sales companies, and others) your franchisor has made arrangements to use.

If you are Buying a Franchise from an existing owner, you should also get answers about how existing and ongoing tax liabilities and purchase payout will be handled.

Franchisor Registration:

The franchisor and the franchise broker should be registered with the state.

An example of a “strict regulation” state is Illinois. In that state, the regulator is the Attorney General’s Office, Franchise Bureau. You could call (217-782-4465; TTY: 1-877-844-5461) to get information on the business and legal history (e.g., complaints on file) of franchise brokers and franchisors registered with the State of Illinois. The state law, which imposes disclosure regulations more extensive than the form FDD, is the Illinois Franchise Disclosure Act of 1987 (815 ILCS 705/1 et. seq.)

Franchise Disputes:

If you have a dispute with a franchisor, three things need to be remembered.

Don’t sign their agreements and then expect the state to save you: Franchise agreements are still valid even if the franchisor is unregistered. You can get damages for failure to disclose material facts, but then you have to prove losses, and the franchisor may be off the hook with repayment of your fee.

Don’t expect to litigate in your home state––or in court. Most franchise agreements have binding arbitration clauses, and choice of forum terms that mean you have to fight franchisors on their home court – often Nevada, where corporation statutes are friendly to defendants, not plaintiffs.

Don’t expect to win if your suit is late. You’d have 90 days after notice of a violation by a franchisor, one year from the date you discover a violation of disclosure rules, or at most three years from when it would have been reasonable for you to know of a possible violation (such as three years from a notice of termination.)

What About Your Business Site?

A franchisor like McDonalds brings in investors to join the company in buying retail corners, and then makes most of its money by the terms of the retail gross lease (share of gross receipts per square foot) it gets from you. Others may help you get sites, but leave negotiation of details to you:

Can you afford the terms?
What part can or must you play in obtaining your site?
How much will you need for the design and build-out of your site prior to opening day?
Local building and operations permits, zoning, and other business regulations may also be relevant to a site’s viability.

Do I Need to Incorporate?

Individuals usually form a business entity to act as “franchisee.” This entity then enters into the agreements with the franchisor, master franchisee, or area agents offering the franchise. A few of the issues to think about, when putting together your business entity:

* Liability: Business entities (corporations, LLC’s, LP’s, business trusts, etc...) exist to limit investor’s liabilities to their investment amounts, to enter into contracts, to take in investments, etc.... They don’t limit your liability for not having enough capital, or not doing everything the organization statute requires to register the new company. Good insurance is also as important as or more important than entity status in protecting you from claims.

* Taxes: State taxes may make one form or another of legal entity preferable. For example, sole proprietorships pay no corporate personal property replacement tax in Illinois, partnerships pay 1.5%, and corporations pay 2.5%. At the federal level, for income tax, the big difference is between “pass-through” entities classed as partnerships, and corporations. Partnerships (which include LLC’s, business trusts, and subchapter S companies) and individuals pay no entity-level federal or state income tax on net profits. Instead, owners pay individual shares of entity gains on the owner’s separate tax returns. If the business makes money, paying tax on those earnings as an individual may push you into higher tax brackets.

* Partners: You may need investors or active partners to get enough money for franchise fees and other costs of franchise operations. Get written agreement to the amounts to be invested by each party, the management and agency rights that you retain as operator versus those (if any) granted to investors, the terms of sale of investments allowed (if any), and any other rights and duties of active or passive partners. Your franchise system may prohibit multiple-investor franchisees; check this before you arrange such financing.

Operations: Conflict and Trade Regulation Issues

Accounting and Business Operations Conflicts:
Your due diligence before purchasing a franchise (agreeing to the fees and signing all agreements) should cover the organization’s business plan, business practices, franchisee relations, and future prospects as carefully as it does your own capacity to work well within their system.

You should examine the litigation and complaints histories of any franchisor. Some systems work well for all parties, without excessive overcharges to franchisees for equipment, parts, and supplies. Others show problems with quality control, parts and supplies availability, accounting errors and excessive fees, or other problems, even when system operators are not under major financial stress.

Where franchisor go into bankruptcy, or lose key vendors, franchisee operations may be adversely affected. Where the franchisor’s business model stops working well, whatever the reason (for instance: excessive competition, insufficient advertising, insufficient new product to hold customer loyalty, pricing and quality problems), franchisees and franchisors may come into additional conflict.

Antitrust and Trade Regulation

If they aren’t making the money they expected, franchisees and franchisors (and the members of the franchise supply chain) may sue each other under antitrust, business fraud, and other trade regulation laws. Cases have come up raising the following types of issues:

exclusive Franchises and refusals to deal as violations of antitrust laws against restraint of trade
territorial confinement and customer restrictions as antitrust or “contract of adhesion” or other unfair business practices violations
resale price control and price management as antitrust violations, and
control of product purchases and sales as required to protect other franchisees from bad practices by other outlets, or as excessive and unreasonable attempts to drive a franchisee out of business prohibited by unfair trade practices laws, or as insufficient, with consequent loss of trademark protection for the franchisor, etc...

William A. Price is an attorney in private practice in Warrenville, Illinois. His clients have included franchisees, franchisor advisory organizations, franchisors and a variety of other private companies and their principals.

Mr. Price teaches high-technology entrepreneurship and business law classes at the Stuart Graduate School of Business of the Illinois Institute of Technology. He is a member of the Board of the Midwest Entrepreneurs Forum, and a member of the advisory board for the COD Small Business Development Center.

Mr. Price’s public service includes a term as the state Small Business Utility Advocate and service as chairman of the subcommittee that wrote both versions of the Illinois Limited Liability Companies Act. He currently chairs the Corporation, Securities, and Business Law Section Council of the Illinois State Bar Association (ISBA). Books include Limited Liability Organizations (Specialty Technical Publishing, 2000-2006) and the ISBA Handbook of Illinois Administrative Law.