George Washington said it best: “Government is not reason, it is not eloquence – it is a force! Like fire, it is a dangerous servant and a fearful master; never for a moment should it be left to irresponsible action.”

Do states actually have the constitutional ability to impose an income tax on out-of-state franchisors? The Commerce Clause and Due Process Clause of the Fourteenth Amendment to the U.S. Constitution set limits on a state’s ability to tax franchisors located outside their boundaries. The U.S. Supreme Court has certainly made it clear that a company must have a physical presence in a state to be subjected to a state sales and use tax. Unfortunately, Franchisors do not have the same clear road when exposed to a state’s income tax laws and regulations.

As states have lost valuable revenue sources over the years they have struggled to find replacement income. One substitute for the shortfall has been found by taxing the income out-of-state franchisor’s are receiving from franchisees. In the case of KFC Corp. v. Iowa Department of Revenue, the Iowa Supreme Court recently approved the state’s practice of imposing an income tax on franchisors where their only connection to the state was the use by franchisees of the franchisor’s intellectual property. Other states like Florida, Georgia, Minnesota, New Mexico, Oregon, Rhode Island and Wisconsin have enacted specific legislation or regulations imposing an income tax, regardless of physical presence, when there is a use of intangibles within the state. Some states like Colorado, Connecticut, and Ohio set a baseline amount before imposing an income tax on economic presence alone. The Department of Revenue in Maine is notifying out-of-state companies with solely an economic presence that they are subject to the state’s tax laws. Arizona, California and Delaware also appear to have taken the position that out-of-state franchisors are subject to their state income tax. Several other states whose statutes or regulations are silent on a physical presence appear to tax franchisors based upon the licensing of intangibles: Alaska, District of Columbia, Hawaii, Illinois, Kansas, Kentucky, Mississippi, Montana, New Hampshire, North Dakota, Pennsylvania, Utah and Vermont. Nebraska and Virginia seem to tax any activity that is constitutional or that federal law allows. The Arkansas Department of Finance and Administration of the Commissioner of Revenue has adopted a regulation similar in effect to that of Iowa.

Franchisors are no doubt faced with a heavy responsibility to determine whether a state’s tax laws are applicable to their business. Indeed, the responsibility is one that cannot be ignored. I recently was contacted by a franchisor seeking assistance in a royalty income tax dispute with a state other than its domicile, which wanted the franchise company to file 10 years of back tax returns. If you are contacted by a state agency do not ignore the questionnaire. If you never respond you will very likely be hit with an estimated assessment or an assessment based on an artificial amount constructed by that state. Uncontested assessments lead to judgments that can be enforced in your home state. If you receive a questionnaire consult your attorney or tax advisor familiar with multistate transactions. If your company had no physical presence in a state but had franchisees in the state, there are portions of the questionnaire that probably require a qualified response.

Perhaps the most economical way for franchisors to protect themselves and to cover all their bases is to include a provision in their franchise agreement requiring franchisees to pay any tax assessed by a state on the franchisor’s royalty income.


As states continue to search for replacement revenue franchisors must become proactive. Know the states that tax royalty income where a franchisor has no physical presence. Join other franchisors to actively engage in advocacy in those states, whether through new legislation or through the courts. Also, use franchise agreement provisions requiring franchisees to be responsible for state income taxes accessed against royalty income.

Remember the words of Thomas Jefferson – “A little rebellion now and then is a good thing.”

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