Top Franchisee Missteps and Mistakes

With renewed SBA funding by the current administration, now is the time to start thinking of buying a franchise. If you are looking at buying a franchise, there are common missteps and mistakes that you want to avoid. Most of these are simple and will not cost any additional money, but they are incredibly important to keep in mind as you negotiate yourself through the thick packet of documents know as the Franchise Disclosure Document and the Franchise Agreement. This is our top 10 list of common franchisee missteps and mistakes (in no particular order):

1. Not Reading Everything. To make an informed decision as to whether or not this is a good investment for you, you absolutely need to read every document provided to you. It seems like a daunting task, but it is worth it. This is a legal obligation you are considering and if you don’t know what your obligations are, you cannot make an informed decision and I promise, you will discover down the road that you agreed to something you had no idea about. Don’t be surprised or caught off guard.

2. Not Taking Enough Time. You may feel pressured to read through everything and sign on the dotted line quickly, but the truth is, you have time so take it. Remember, you have at least 14 days before you can sign anything or pay any money.

3. Having the Right Documents.  Make sure you have the most current Franchise Disclosure Document (FDD) and Franchise Agreement. If you are talking to a franchisor in June 2012 but you have a 2011 FDD, then there is something wrong. Remember, the franchisor is under federal and state requirements to have an annually updated FDD to provide to prospective franchisees. 

4. Failure to Understand the Product/Service. The franchise may appear to be a great idea, but do you really understand what you are selling or offering to the public? You need to be comfortable with your business and to know how to sell it. This due diligence step is often overlooked to the detriment of the franchisee.

5. Failure to Contact Current and Prior Franchisees. This takes time, but remember #2 above –take time. This includes calling up all the current and former franchisees in a small system and a lot in a mid-size to large-size system. You need to ask questions such as: a) how is their relationship with the franchisor; b) are there problems with the franchise system that are or are not being addressed; c) do they still feel like it was a good investment; d) what is their revenue; e) any advise in making the decision to purchase this franchise. This is just a short list and there are a lot of questions you can ask franchisees. They are an incredibly valuable resource that is often overlooked.

6. Failure to Have Adequate Initial Financing. While the FDD discloses the amounts estimated to start your franchise business, you need to plan for the unexpected. Not having sufficient working capital while in the initial phase of your franchise business could leave you without a business at all.

7. Failure to Have Sufficient Long-Term Capital. The franchise system you purchase is going to change. You will be expected to remodel, to upgrade software, hardware and equipment, and to possibly rebrand the business –all your own expense. Planning for the future by having planned for long-term capital needs will help sustain your franchise business.

8. Underestimating the Time Commitment. Buying a franchise is starting a business. You have a head-start in that you have a recognizable name, but you are still the owner of your own business and that takes a lot of your time. Make sure you are prepared to dedicate the time necessary to make your franchise business succeed.

9. Not Getting It In Writing. Whether you have an experienced franchise attorney helping negotiate for you or not, you need to make sure you get everything in writing. No matter how great the franchisor is today, if there is ever a dispute, you will wish you had that promise to lower royalties in 6 months in writing.

10. Not Marketing. There is a reason that most franchise agreements require a franchisee to spend money on marketing and advertising. Advertising and marketing works. Products and services don’t sell themselves. And remember, your competitor is spending time and money on marketing and advertising so don’t lose a sale to them.

More on Royalty Taxation

We have had a few requests to provide more information on the taxation of royalties received by franchisors. Ultimately, the KFC case (see KFC Corp. v. Iowa Department of Revenue, 792 N.W.2d 308 (Iowa 2010) held that having a trademark in a state is the equivalent of physical presence, thus satisfying the physical nexus required under the Supreme Court ruling in

Quill Corp. v. North Dakota, 504 U.S. 298 (1992). This is a topic that should be carefully watched and discussed with your legal counsel.

Below are links to several articles that provide more information on this topic. We are also preparing a more in-depth article which should be available in the coming months.

A great article summarizing these topics from the American Bar Association: http://www.americanbar.org/newsletter/publications/franchise_lawyer/5_state_taxation.html

Link to the IFA's summary of this issue: http://www.franchise.org/Franchise-Industry-News-Detail.aspx?id=51948

Link to the Iowa Supreme Court's ruling: http://www.iowacourtsonline.org/Supreme_Court/Recent_Opinions/20101230/09-1032.pdf?search=KFC+COrporation

Franchisor Royalties and Income Tax

In recent years we have noticed more states starting to impose a state income tax on franchisor royalties, even where the franchisor has no physical presence in that state. In 2011, the Supreme Court of Iowa, in KFC Corporation vs. Iowa Department of Revenue, held that Iowa was allowed to assess an income tax on the franchisor, on those royalties paid to the franchisor by KFC franchisees in Iowa. This decision was made despite the fact that KFC Corporation had no physical presence in the State of Iowa. The U.S. Supreme Court has declined to review the ruling.

This ruling, along with other recent court rulings in various states indicates that most states will likely begin, or continue, to aggressively pursue the collection of income taxes off of royalty income from franchisors, regardless of their physical presence in a state. Franchisors need to prepare for the possibility of having to pay income tax in various states. We suggest each franchisor with franchisees in multiple states begin working with an accountant to analyze taxable income with respect to these types of tax liabilities.

IRS and Independent Contractors

The Internal Revenue Service (IRS) has announced it is undergoing an extensive initiative to identify businesses that are incorrectly classifying employees as independent contractors. For those businesses that choose to reclassify their independent contractors as employees the IRS is charging a small penalty payment to cover past payroll taxes. For those businesses who choose to continue with the independent contractor status, but in reality have employees, the IRS could audit the business and assess a large penalty fee.

 

If you are paying independent contractors that may be considered to be employees, you need to know the difference so that you can avoid a potential audit by the IRS. However, the distinction between an independent contractor and an employee is fuzzy. To help you with this determination, below is a brief summary of some points the IRS will look at. However, as this is a difficult area of the law and one that is undergoing scrutiny, speaking with legal counsel will help you better determine if you are in an employee relationship or not.

The independent contractor (“IC”) must:

            1.  Have an independent business. A business license is helpful.

            2.  Be free from the control and direction of your business i.e. is independent.

            3.  Work outside of your place of business.  

 

How To Clean Up Your Business

Spruce up your work by chucking these eight productivity pitfalls. No Swiffer required.

By Gwen Moran   |   Entrepreneur Magazine - May 2011

Spring cleaning isn't just about clearing cabinet clutter and that space behind the toilet. It's also a good time to get rid of the tasks, people and situations that drain time, money and energy from your business--and you. Here are eight productivity pitfalls to cart to the curb.
1. Scattered day plans.
Failure to plan their days is the No. 1 reason business owners waste time, energy and money, says New York City-based time-management expert Julie Morgenstern, author of Never Check E-mail in the Morning: And Other Unexpected Strategies for Making Your Work Life Work. By not planning their days, they tend to become reactive and distracted, diminishing their productivity and the revenue they can generate. Although a daily to-do list is a start, Morgenstern recommends planning a three-day arc. By looking at a three-day period--and the meetings, deadlines and other demands on your time--you can make better decisions when surprises or emergencies arise. A three-day plan also gives you a clearer idea of when you can postpone activities without overbooking your future. Morgenstern advises spending at least a few minutes each day updating your three-day plan.
2. DIY syndrome.
Morgenstern estimates that 75 to 80 percent of the small and midsize businesses she consults with waste employee salaries, including their own, by not focusing each person's time on the optimal task for that person. Kristin Marquet, founder of communications firm Marquet Media in New York City, found this to be her experience. When she mapped out how she was spending her time, she found she was devoting about 10 hours each week to administrative tasks. At her hourly rate of $100, she estimates she lost approximately $10,000 by trying to do everything herself. After that realization, Marquet hired a bookkeeper, writer and website designer, who cost one-forth of the revenue she would have lost if she had handled the tasks herself. "Although you may feel as if you don't have time to train anyone, spending six hours training someone on a two-hour-per-week task saves you nearly 100 hours per year," Morgenstern says.
3. Disorganized direction.
To make the delegation process more effective and less time-consuming, Bakersfield, Calif.-based business growth consultant Russell S. Allred, co-author of Best Practices of High Performance Entrepreneurs, recommends creating task-related systems and processes. Write a list of steps for each task you perform regularly in your workplace and the best practices for completing those steps. Many people learn through observation, so ask your employees to shadow you to see how you perform the tasks, he says. For maximum efficiency, create process sheets for as many activities as possible, and try to train more than one employee in each. If the employee who usually handles the task calls in sick or leaves, someone else can fill in--or, at least, you'll have an easier time training a replacement.
4. Untamed distractions.
A survey by home and office product company Brother International Corp. in April 2010 found that an estimated 38 hours per employee are lost looking for misplaced items in the office each year. And let's not think about how many hours are spent watching cute animal videos online. Many people have no idea how to manage the overwhelming amount of communication that comes their way on paper and electronically, says productivity consultant Kimberly Medlock, founder of Productive Matters in Olive Branch, Miss. To cut down on distractions and time-sucks, clean up your act, she says. Develop hard-copy and electronic filing systems to help locate important papers and information more quickly. Limit e-mail check-ins to certain times of the day so that you're not constantly interrupted by the "ping" of a new message, and unsubscribe from any recurring e-mail you don't need. If social media is a problem, look into tools such as Anti-Social or RescueTime, which put up a wall between your computer and distracting sites for blocks of time.
5. Leaky expenditures.
By checking his monthly expenses closely, Eli Mechlovitz, co-founder of GlassTileStore.com, an online glass tile retailer, found a variety of unwanted subscriptions, warranty programs, fee-based website analytics programs, utility bill errors and other incorrect or unwanted charges. Eliminating these budgetary leaks has saved his Brooklyn, N.Y., company approximately $4,000 per month. "It's so easy to add a subscription here and there or a small program that doesn't seem like it costs much. But over time, these things add up," he says. Every quarter, be sure to review where the money is going, he advises, and discontinue or fight unnecessary or incorrect charges.
6. Collecting (all) customers.
Maria Marsala, a business coach in Poulsbo, Wash., finds that many of her clients waste time and energy serving the wrong customers. She encourages them to define their "ideal" customer--the person or entity that will pay a fair price for their product or service, value their business, return and buy from them again and generate referrals. The greatest marketing investment and effort should be devoted to finding and courting those ideals, she says. Marsala initially marketed her coaching services to all small-business owners. She decided to define her niche in the business-to-business world serving established business owners who didn't balk at her fees. Then she created an opportunity to sell to a different audience by developing a series of CDs for startup or more cash-strapped business owners.
7. Energy-sucking employees.
When Mechlovitz has trouble with unproductive or negative employees, he tries to move them into positions that better suit their skills. In one case, a warehouse worker who wasn't good at picking orders turned out to be an exceptional packaging team member. But if an employee isn't a good fit or is miserable, he says, you have to end the relationship--quickly. A negative employee "sucks all of your creativity out of you and leaves you drained," says consultant Allred. "And why? You're the boss. Why are you messing with this person?" Of course, it's more complicated when the individual is a family member or close friend. Have a frank discussion to find out why the person is unhappy and what can be done to change the situation. At the very least, you need to stop the person from spreading the negativity, he says.
8. Persistent procrastination.
If you constantly avoid tasks or put off work until the last minute, you need to figure out why, Morgenstern says. Burnout could be from being overworked, but she often finds that procrastination is rooted in uncertainty or intimidation. If a project seems too big, procrastination can be a coping mechanism. She suggests breaking the task down into manageable steps you can do in shorter chunks of time: "You don't get eight hours to focus on something anymore. You'll get a 30-minute or one-hour window. Learning to chunk your work so that you can look at the time you have and figure out what part of the project you can finish in that time will help you find a place to start to get it done."

Franchisor & Prospective Franchisor Brown Bag

The Franchise Business Law Group is hosting a FREE brown bag seminar on Wednesday, June 1, 2011 from 12:00 to 1:00pm. This seminar will address "What Every Franchisor and Prospective Franchisor Should Know".

Among the topics we will discuss are:

The importance of complying with FTC and State regulations
Growth strategies
Branding

You must be a current or prospective franchisor.
Seating is limited to the first 10 registrants so call early to reserve your space.Validation for parking is provided.
Call us at 801-575-5000 or email Kara at kthompson@toolaw.com.

Date: Wednesday, June 1, 2011
Time: noon to 1:00 pm
Location: 57 West 200 South, Ste 350, Salt Lake City, Utah 84101

Should I Incorporate? Choosing the Form of Entity for Your Business

Choosing the form of entity by which to conduct business is one of the first, and often most important, questions faced by someone starting a business. Several factors determine which form of business entity is most appropriate for a particular business, including protection of the owners of the business from debts, obligations and liabilities of the business, and achieving favorable tax treatment. This article will help you understand the basic differences in business entities and the advantages and disadvantages of the several options from which to choose. In making your ultimate choice, you should discuss these and other factors with your legal and tax advisors.

In Utah, you have several options when choosing the form of entity for your business. The entities discussed in this article are: A) Sole Proprietorships, B) General Partnerships, C) Limited Partnerships, D) Corporations, E) S-Corporations and F) Limited Liability Companies. Not discussed are more specialized entities such as professional corporations, non-profit corporations, limited liability partnerships and business trusts.

A. SOLE PROPRIETORSHIPS: A sole proprietorship is a single individual who owns and operates a business typically using his or her own assets. The sole proprietorship is the simplest form of business entity, with little distinction between the owner and the business.

1. Advantages. A sole proprietorship is simple and requires no formalities or state filings. A sole proprietorship avoids the double taxation disadvantage of corporations. The owner may deduct business expenses and losses from his or her personal income.

2. Disadvantages. An owner is personally liable for all obligations of the business. Creditors of the business can seek recovery from the owner’s personal assets, as well as business assets. Also, all profit may be subject to self-employment tax, even if part of the profit is attributable to a return of capital.

B. GENERAL PARTNERSHIPS: A general partnership is an association of two or more persons formed for the purpose of conducting a business for profit. A partnership may be created by a formal agreement or merely by the parties’ actions.

1. Advantages. The biggest advantage of a partnership is its relatively favorable tax treatment. There is no separate tax at the partnership level and individual partners get the benefit of business expenses and deductions to offset income from other sources. Partners may also specially allocate income and losses, thus allowing them to shift tax benefits and burdens. A partnership can be formed and operated with minimal formality and no filings or agreements are necessary. Partnerships are relatively easy to manage.

2. Disadvantages. Each partner is jointly and severally liable for all obligations of the partnership. On dissolution of a partnership, a creditor of the partnership can sue any of the partners personally for unpaid partnership debts. In the absence of any agreement to the contrary, the death or withdrawal of one partner dissolves the partnership. Management of a partnership can be difficult if many partners are involved or if partners do not get along well. Interests in partnerships are not freely transferable. There is no centralized management in a partnership, and any partner can bid the partnership and the other partners in any matter of partnership business. Raising capital is difficult in the partnership form since the partnership cannot obtain funds through broad ownership distribution. It takes at least two persons to form a partnership.

C. LIMITED PARTNERSHIPS: A limited partnership is a partnership comprised of one or more general partners who operate and manage the business, and one or more limited partners who do not actively operate or manage the business. Articles of limited partnership must be filed with the state. A partnership agreement would normally describe the rights and duties of the partners.

1. Advantages. A limited partnership enjoys the same basic tax advantages as a general partnership, subject to the passive income and loss rules, and except that limited partnerships may be more limited in how they can specially allocate income and losses. The limited partnership affords investors limited liability, much like a corporation, so long as they do manage the business.

2. Disadvantages. The general partners of a limited partnership are liable for all partnership obligations. As with a general partnership, the death or withdrawal of a general partner will dissolve a limited partnership, absent a partnership agreement provision to the contrary. Although more freely transferable than general partnership interests, limited partnership interests are still not as freely transferable as corporate interests.

D. CORPORATIONS: A regular corporation, or “C Corporation” to the IRS, is the most common form of entity for doing business. A corporation is a legal entity, formed pursuant to state law that exists separately from its owners. Articles of incorporation must be filed with the state. The management structure and financial and voting rights of the shareholders are typically embodied by bylaws or shareholder agreements.

1. Advantages. It is difficult to “pierce the corporate veil” to hold shareholders, officers or directors personally liable for corporate obligations. Protection from liability is the principal reason a corporation is preferred as a form of business entity. Also, with a long history of use in this country, corporate law is well developed and fairly standard throughout the states, and therefore legal issues are more predictable and more readily settled. Ownership interests (stock) in a corporation are freely transferable.


2. Disadvantages. A C corporation’s income is subject to double taxation: first on the net income when it is earned by the business, and again on the dividends when paid to the shareholders out of the corporation’s remaining income. Also, a corporation requires more formalities and is somewhat more complex than a sole proprietorship, a general partnership or a limited liability company. Annual reports must be filed and corporate formalities, such as keeping proper corporate minutes, should be followed to maintain the separate identity of the corporation. Also, corporations are less flexible from a tax standpoint than other entities.


E. S-CORPORATIONS: An S-corporation is a corporation that, by complying with IRS requirements, avoids the double taxation of C corporation, and is taxed more like a partnership than like a C corporation. Articles of incorporation must be filed with the state and a form must be filed with the IRS indicating the corporation’s election to be treated as an S-corporation.

1. Advantages. Shareholders enjoy the same protection from liability for the obligations of the business as shareholders of a regular corporation. The primary advantage of an S-corporation over a C corporation is the avoidance of double taxation. Another advantage is that, to the extent there are losses in the corporation, those losses may be passed through to shareholders to be offset against shareholders’ income from other sources, subject to certain limitations.

2. Disadvantages. An S-corporation is limited by the number (100 or less) and type of shareholders it can have. It is also limited to one class of stock. These limitations may make it more difficult for an S-corporation to raise capital. Also, unlike a partnership, income and losses cannot be specially allocated to shareholders.

F. LIMITED LIABILITY COMPANIES: A limited liability company (LLC) is a relatively new form of business entity in Utah combining features of partnerships and corporations. An LLC has the tax advantages and operational flexibility of general partnerships, together with the limited liability protection of a corporation. The LLC is a separate legal entity which is organized by one or more persons or entities. Articles of organization must be filed with the state. The rights of the owners or “members” with respect to management and financial matters may be set forth in an operating agreement.

1. Advantages. Members of an LLC are not personally liable for the obligations of the company. LLCs enjoy favorably flow-through tax treatment without double taxation. LLCs can specially allocate income and losses among members. There is no limit on the number or type of members, and an operating agreement can, in effect, create different classes of ownership interests. There are relatively few formal requirements to create and operate an LLC. Finally, LLCs also offer certain other tax advantages of an S- corporation.


2. Disadvantages. One disadvantage of an LLC is that it is still the newest form of business entity and as such, is still somewhat untested in court cases. There still remains some uncertainty with respect to issues such as piercing the veil of an LLC, the treatment of the LLC and its members in bankruptcy, and the like. However, each year adds more experience so these concerns are becoming less disadvantageous. Another area of disadvantage of the LLC is that there still is no strong uniformity of state laws governing LLCs. An LLC entity conducting multi-state business may find it difficult to comply with the laws in all the various states. Also, to the extent an LLC engages in business in a state which has not passed LLC legislation, there is a risk that a court might not recognize the limited liability of members, and might hold the members personally liable in that state for the obligations of the business. However, most every state now recognizes LLCs as a type of business entity.

Each business is different, but determining which factors are most important to your business will help you better determine which type of entity will work best for you.