It would seem that death and taxes are more certain than ever in Iowa following that state’s Supreme Court’s decision in KFC v. Iowa Dep’t of Revenue. In KFC, the Iowa Supreme Court became the first court to expressly find that a franchisor had a sufficient nexus with a state to justify imposition of income taxes where its only connection with the state was the use of the franchisor’s intellectual property within the state.
As a result of this decision, many franchisors are re-evaluating the commonly held view that state income taxes cannot be imposed based on the grant of a franchise alone under the constitutional requirement of a taxpayer’s “physical presence” in a state. And, given the aggressive measures that many states are taking to locate additional revenue sources in these past few years, many states have followed or are likely to follow KFC. In fact, a handful of states have legislatively determined that the licensing of intellectual property without more is justification for the payment of income taxes.
So in states where the issue is still legally uncertain — caught between the possibility of being charged with the payment of back taxes, penalties and interest under the KFC rationale and administrative costs involved with voluntarily filing taxes in all states in which a franchise is located — what should a franchisor do? Should a franchisor, “out of an abundance of caution” and in light of the Iowa Supreme Court’s decision, voluntarily pay taxes on royalty revenue in a state?
Many things should be considered in this analysis. A franchisor’s accounting and tax team should weigh the potential costs of paying back taxes if a tax deficiency is assessed by a state v. the administrative burden and cost of voluntarily filing a tax return in a state where a franchise is located. Franchisors should be aware that most states do not implement a statute of limitations until a tax return has been filed — which means the state can assess deficiencies, interest and penalties as far back as it is willing to go.
A franchisor that decides to file a return in a state on its own initiative should be aware that states will not forget about prior taxes. In Georgia, for example, the penalty if the state decides that back taxes are owed is up to 25% of the unpaid tax plus 12% per year. So, in a state like Georgia, if the royalty income is high and the deficiency goes back many years, then the total liability imposed for prior taxes, interest and penalties could be significant.
One option to mitigate liability for prior taxes, interest and penalties is participating in a state’s Voluntary Disclosure Program (VDP). If potential tax liability is high, a franchisor that files voluntarily is likely better off participating in VDP. By doing this, the franchisor admits that it did not pay state taxes in the past so the state does not spend money on an audit. In return, the state limits the tax liability by only looking back for a specific number of years (usually three or five) and possibly waiving any penalties. Interest is still assessed however.
Whether or not a franchisor decides to take the initiative to file in a state where the law is unclear, or is subject to the demand for payment of taxes on royalty revenue by a state in which the matter has been decided or legislated, a franchisor may be able to alleviate the sting of back taxes by filing an amendment for an overstatement of income in its home state. It is important to note that in some states, an overstatement amendment is only permitted for a certain number of years from the date the original return was filed or taxes paid. Georgia, for example, only permits an amendment within three years after the date a return was filed or the tax was paid, whichever is later. For Georgia franchisors, therefore, an overstatement refund would not be given if back taxes owed in another state relate to a period that is more than three years prior to the date of a return or payment of taxes – resulting in the payment of income taxes on the same revenue twice.
In conclusion, franchisors are cautioned to file in states that have already adopted the rule of KFC. In state where the law is uncertain, franchisors are cautioned to mitigate the risk that high amounts could be assessed for back taxes, interest and penalties taking into account tax laws, royalty income earned, and the ability to receive overstatement refunds (in the state in which the franchisor is domiciled.) For relatively new franchisors with franchises in a few states, the proactive filing of state income tax returns could avoid a complicated analysis of these issues.
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