When a franchisor in one state sells a franchise in another state, must the franchisor qualify to do business in the franchisee’s state? Does franchising, by itself, constitute “doing business” or “transacting business” in the franchisee’s state? This article looks at these and other questions of qualification under state entity laws.

A corporation or limited liability company is a creature of the state in which it is formed. When an entity formed in one state establishes an office in another state or otherwise engages in intrastate business in the other state, the corporate law or limited liability company law of the other state requires the entity to “qualify” to do business there.

An entity “qualifies” by filing a simple application for authority to transact business in a state and paying a small fee. Section 15.01(a) of the Model Business Corporation Act (3d ed. 1984) (the Model Act) provides that “[a] foreign corporation may not transact business in this state until it obtains a certificate of authority from the secretary of state.” The entity must also pay applicable state fees and taxes and file annual or biennial reports to remain qualified in the state.

With one exception, state corporate laws view interstate franchising, by itself, as business done in interstate commerce that does not require qualification in the franchisee’s state. See, e.g., Snelling & Snelling, Inc. v. Watson, 254 S.E.2d 785, 792 (N.C. 1979); Ommani v. Doctor’s Associates, Inc., 789 F.2d 298 (5th Cir. 1986) (Texas law). The anomaly is a “registration” requirement in Maryland for corporations conducting interstate business. But the Court of Appeals of Maryland has made it clear that a state cannot bar a corporation from maintaining a suit in a court in the state when the corporation is engaged in wholly interstate or foreign commerce. Yangming Marine Transp. Corp. v. Revon Prods. U.S.A., Inc., 536 A.2d 633 (Md 1988).

The conclusion should be the same for limited liability companies, which became a popular form of business entity in the 1990s for franchisors and other businesses. The qualification provisions of the limited liability statutes essentially mirror those of the corporation laws. Section 802 of the Revised Uniform Limited Liability Company Act (2006) (the LLC Act) provides that a foreign limited liability company may not transact business in the subject state until it obtains a certificate of authority from the secretary of state.

Local Jurisdiction, Taxation 

Corporation laws and limited liability company laws are not the only laws that deal with the concept of “doing business” or “transacting business.”  This concept also comes into play in questions of local jurisdiction and taxation. Generally speaking, a much greater degree of in-state activity is required for qualification purposes than for either jurisdictional or taxation purposes. In other words, an entity may be subject to the jurisdiction of courts in the franchisee’s state and subject to taxation by the franchisee’s state, yet may not be required to qualify to do business there.

Qualification under the state entity laws ensures that the out-of-state entity will pay taxes in the other state and will be subject to the jurisdiction of the local courts. Qualification makes it easier for state authorities or private entities to bring a lawsuit or enforce local laws against the entity and to tax the entity. But the entity can be subject to local taxation and jurisdiction without being required to qualify to do business under the corporation law or the limited liability company law.

What Is ‘Doing Business’? 

Most corporation and limited liability company qualification laws do not positively define the terms “doing business” or “transacting business.” Rather, many of these laws give guidance by listing examples of activities that do not constitute transacting or doing intrastate business. Exceptions under § 803 of the LLC Act, like those under § 15.01(a) of the Model Act, include, for example: maintaining, defending, or settling a proceeding; holding meetings of the board of directors or shareholders; maintaining bank accounts; selling through independent contractors; soliciting or obtaining orders if the orders require acceptance outside the state before they become contracts; owning real or personal property; conducting an isolated transaction that is completed within 30 days; and transacting business in interstate commerce. None of these activities requires qualification under the corporation laws or the limited liability company laws.

Although franchising is not listed as a specific statutory exemption, it is generally viewed as interstate commerce and thus not intrastate activity that requires qualification, as explained above.

Activities that do require qualification under the corporation laws and limited liability company laws might include, for example, establishing an office with employees in the franchisee’s state or placing a warehouse in the franchisee’s state.

By contrast, a state might find that a company has “nexus” for sales tax purposes or income tax purposes (which have differing factors) just by delivering goods into a state or attending trade shows in the state, even though the company has no physical assets or employees maintained in the state. Similarly, a foreign corporation may be subject to state court jurisdiction, even if it is not physically present in the state, if it has continuing obligations and a course of dealing with a resident of that state.

Consequences of Not Qualifying 

What is the consequence of not qualifying under the corporation or limited liability company laws in a state in which a company is engaged in business within the scope of those laws? Most states require the company to pay taxes and monetary penalties for the years the entity failed to qualify. The company may also be barred from bringing a lawsuit until it has obtained the appropriate certificate of authority. But most states will allow an entity that brought a lawsuit before it qualified to do business to remedy its failure by complying with the qualification requirements and paying any penalties before litigation begins. Many states allow this remedy even after litigation has begun.

In a minority of the states, including Alabama, Arkansas, California, Indiana, Kansas, Louisiana, Maine, Maryland, Mississippi, New Jersey, Ohio, Oklahoma, South Carolina, Vermont, and Virginia, the penalties for failure to qualify appear to be more severe, ranging from unenforceability of contracts to potential criminal liability. But these more stringent sanctions do not appear to be vigorously enforced.

While the state laws appear to be consistent in viewing franchising as an interstate activity that does not require qualification, one recent development that could threaten the well-established status quo. That development comes from the unexpected field of labor law. Who could have predicted just a year ago that the National Labor Relations Board General Counsel would take the position that franchisors and franchisees are joint employers of the franchisee’s employees? Would this mean that a franchisor would have to qualify to do business in each state in which it franchises? We shudder to consider the consequences.