Earlier this year, we reported that in KFC Corporation vs. Iowa Department of Revenue, the Iowa Supreme Court upheld the state’s ability to assess income tax on KFC Corporation and other out-of-state franchisors who, despite not having a physical presence in Iowa, nonetheless derive revenue through its franchisees. The Iowa Supreme Court held that a franchisor’s physical presence in Iowa is not a required element in determining whether a sufficient tax nexus exists to justify the imposition and collection of state income tax.

Recently, the United States Supreme Court declined to review the Iowa Supreme Court’s ruling with respect to physical presence and substantial tax nexus. The implications of the Supreme Court’s declining to review the KFC nexus case are potentially far reaching in that other states, including Iowa, will now begin to aggressively pursue the collection of income tax from out-of-state franchisors who have no physical presence in a state. The tax nexus ruling could also affect other areas of interstate commerce where there is no physical presence.

We expect that states will begin adopting their own tax nexus analysis based loosely on the Iowa Supreme Court’s analysis and will soon require out-of-state franchisors to begin filing income tax returns if they are not already doing so.

Franchisors with significant presence in multiple states should begin preparing for what seems to be an inevitable outcome with respect to reporting and paying state income tax in each state they will be deemed to have a sufficient tax nexus.

Franchisors may consider spreading the cost of additional tax among their franchisees through higher fees or higher cost of goods. This could result in the consumer’s paying a higher price for the franchisor’s good or service.

If required to file and pay state income taxes, franchisors who previously were not subject to state income tax need to begin analyzing their taxable income with respect to those states in which they derive franchise income not only to determine their potential state income tax liability, but also to begin planning with respect to reporting and accounting procedures.

Franchisors should conduct tax planning and analysis at the state level where they will now be required to report and pay income tax, but the analysis should start at the federal level with respect to income, expense, deduction and planning opportunities to minimize tax exposure at the state level. As part of the analysis, franchisors may want to examine their current franchise structures to determine whether income and deduction items are properly characterized.