Editor’s Note:  Here’s a must read article as your franchise increasingly appears in the cross hairs of states seeking new sources of income tax revenue.  Look for the complete article in Franchising World’s August magazine. By Hugh W. Goodwin

The United States Supreme Court’s decision to decline review of the Iowa KFC decision will likely further embolden states to assert income tax nexus against out-of-state franchisors.  Franchisors can and should challenge unreasonable nexus assertions by state revenue agencies when the state’s position is unwarranted.  The changing state tax landscape, however, may force franchisors to deal with complex income apportionment and allocation provisions in multiple jurisdictions.   Franchisors that face increased state tax filing obligations in a post-KFC world can still minimize their tax liabilities by understanding the nuances of state income tax laws.  California provides franchisors choices on reporting income by offering taxpayers an annual election to apportion income under one of two apportionment methods:  single sales or three factor.  Recently issued regulations diminish the possibility that California franchisors will face double taxation on designated income streams since income from certain services and royalties paid by non-California franchisees can likely be excluded from the franchisor’s California sales factor.  For non-California franchisors with franchisees in the state, the choice of apportionment method can yield profoundly different results depending on the franchisor’s specific facts and its current profit or loss position.  The ability to choose between two income apportionment methods may also provide a non-California franchisor with the opportunity to shift income outside of the state by undertaking, and tracking, services performed for California franchisees from the franchisor’s home state.  Another tax planning issue that franchisors may need to consider in light of the tax principle employed by most states for “bundled” transactions is the practice of non-segregated franchise fees.  When taxable items and non-taxable items are both provided for a single price, states generally will impose a tax on the entire charge in the absence of segregation of the charge into its taxable and non-taxable components.  If a state employs different rules for assigning income from diverse revenue streamssuch as the licensing of trademarks or other intangibles, and the provision of servicesthen itemizing a franchise fee into separate components may create a tax benefit.   For instance, Texas treats income from the licensing of intangibles as a Texas receipt for apportionment purposes if the franchisee uses the intangible in the state.  Receipts from services performed for Texas franchisees, however, are assigned to the state where the service is performed.  If a franchisor charges a single, non-itemized amount to a Texas franchisee for trademark royalties and services performed outside of the state at the franchisor’s home state location, there is a risk that Texas will treat the entire franchisee fee as a Texas receipt for purposes of computing the franchisor’s Texas apportionment formula because the charge includes an element that constitutes a state receipt.  In addition, states are all over the map in sourcing taxpayer receipts from computer software licenses.  Therefore, it is not difficult to imagine that franchisors who license such software to franchisees may be at particular risk of over taxation.  Accordingly, franchisors will need to consider whether the potential state tax benefits in a given case might warrant an increased level of specificity in separating franchisee fees beyond a single, non-itemized charge. Franchisors that have not typically filed returns in franchisee states must now consider strategies to minimize their state income tax liabilities as state revenue agencies attempt to expand nexus.  Prudent planning can help franchisors minimize their aggregate state income tax burdens. Hugh W. Goodwin is a partner of DLA Piper LLP (US). This document is for general information purposes only and should not be used as a substitute for consultation with professional advisors.  Readers are urged to consult their own tax advisors regarding their specific tax situations.