The economics of franchising have evolved significantly in recent years. As the industry has grown and attracted increased investment interest, many franchise systems have expanded beyond traditional royalty arrangements and introduced additional revenue streams, including technology fees, operational support charges and centralized purchasing programs.
These changes can help franchisors create greater consistency across locations and make day-to-day operations more seamless for franchisees, but they can also create sales and use tax obligations that differ significantly from those associated with historical franchise fee models.
The Shift Beyond Traditional Royalty Models
Historically, franchise relationships were largely built around royalty and licensing arrangements, which generally made sales tax obligations more straightforward. The franchisor typically had state tax nexus in states where franchisees were located, but the intangible royalty income was generally not subject to state sales tax. Franchisees filed sales tax returns in the states where they operated and typically were not required to pay sales tax on the intangible license purchased from the franchisor.
That analysis becomes more complex as franchisors expand their role. With the push to reduce royalty fees while maintaining uniform systems across all locations, many franchisors now charge increased technology fees to franchisees. These fees may include software, point-of-sale (POS) systems, customer support, customer relationship management (CRM) solutions, loyalty programs, inventory management tools and maintenance agreements.
In addition, franchisors often want retail locations to look, feel and operate consistently. To support that uniformity, some franchisors have created entities to purchase materials in bulk and resell those products directly to franchisees. While these arrangements may improve systemwide consistency and operational efficiency, they can also create new sales tax implications for both franchisors and franchisees.
Where Franchise Sales Tax Exposure Can Emerge
State taxes have become increasingly complicated as technology and digital services have become a larger part of business operations. Budget deficits have also made states more aggressive, and these evolving franchising arrangements can create significant state tax exposure.
For example, in states that subject software to sales tax, franchisors should evaluate whether they are required to collect sales tax from franchisees on technology fees. If the franchisor does not collect the tax, franchisees may need to determine whether they are required to self-assess and remit use tax on those charges. These questions can become especially complex when franchise systems operate across multiple states with different tax treatment for software, maintenance, support services and other technology-related offerings.
Why These Issues Often Surface During Due Diligence
In one recent buy-side due diligence engagement, a review uncovered millions of dollars in sales tax exposure for a franchisor. The franchisor purchased its software in a state that does not impose sales tax on software and then resold it to franchisees through a technology-fee arrangement. Many of those franchisees were located in states where software is subject to sales tax.
The review also identified bundled invoices that combined royalty fees and technology fees. Because those charges were not separately stated, the arrangement created the potential for the entire charge to be subject to sales tax. The target had to escrow a significant amount of cash and go through the process of cleaning up the issue post-closing.
This example illustrates how sales tax exposure can accumulate as franchise fee structures evolve. A structure that may appear operationally efficient can create tax issues if software charges, technology fees and taxable products are not properly analyzed, documented and invoiced.
Resale, Use Tax and Nexus Considerations
Technology fees are not the only area where exposure can arise. If a franchisor sells products directly to franchisees and those products are taxable, the franchisor should be issuing a resale certificate to its vendors and collecting sales tax from franchisees on those products.
Franchisees should also consider whether they may be required to self-assess and remit use tax when sales tax is not collected on technology fees, software charges or other taxable purchases. This issue is particularly important in multistate franchise systems where the tax treatment of software and technology-related services may vary by jurisdiction.
Franchisors should also review nexus implications as franchise fee structures evolve. Since the franchisor is deriving intangible revenue from every state where a franchisee is located, it should have nexus in every state where a franchisee operates. That nexus position can create additional filing, reporting or sales tax collection considerations, particularly as franchisors expand beyond traditional royalty models and generate revenue through technology fees, resale activity and other nontraditional arrangements.
Questions Franchisors and Franchisees Should Be Asking
As franchise fee structures become more complex, franchisors and franchisees should consider whether:
- Software-related charges have been reviewed for state-specific tax treatment.
- Franchisors should be collecting sales tax from franchisees on technology fees in states where software is taxable.
- Franchisees may be required to self-assess and remit use tax when sales tax is not collected.
- Support services, maintenance agreements, POS systems, CRM solutions, loyalty programs and inventory management tools are properly evaluated for tax treatment and documentation requirements.
- Royalty fees and technology fees are separately stated on invoices.
- Bundled fee arrangements create the potential for the entire charge to be subject to sales tax.
- Resale certificate procedures are operating as intended when franchisors purchase products for resale to franchisees.
- The franchisor’s nexus position has been reviewed in every state where franchisees operate.
Taking a proactive approach can help identify potential liabilities before they surface during audits, due diligence reviews or remediation efforts.
How Grassi Can Help
As the franchising industry has grown, technology fees have become a major operating cost for franchisors and a significant expense for franchisees. Both parties should take a close look at their revenue sources, expenses, billing practices and multistate sales tax obligations to ensure they are complying with applicable sales and use tax requirements.
Grassi’s Franchise Services and SALT professionals help franchisors and franchisees evaluate technology fee structures, software-related charges, bundled invoicing arrangements, resale activities, nexus considerations and multistate sales tax obligations. Whether your organization is reviewing historical practices, evaluating a transaction or reassessing franchise fee structures, our team can help identify potential areas of franchise sales tax exposure before they become more costly to resolve.
