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BUSINESS
STARTUP--SHOULD YOU BE A "FRANCHISE
PLAYER?"
Launching a business is a little
like walking a tightrope, with any
long-term rewards coming only after
overcoming some risk. Being
well-informed and realistic from the
outset is essential. One of the first
considerations is the legal form that
the business should take. An option
that has the potential for achieving a
good balance between risk and reward
is the franchise.
A franchise is a relationship
between the owner of a trademark or
trade name (franchisor) and an
individual or entity (franchisee) who
contracts to use that legally
protected identification in a
business. The details of the
relationship are controlled by a
franchise agreement, but most
franchises share some common
characteristics. Typically, the
franchisee sells goods or services
that are either supplied by the
franchisor or at least must meet
standards set by the franchisor. In
simple terms, the franchisor provides
the ingredients that come from the
proven experience of an established
line of businesses, while the
franchisee provides the elbow grease
and all of the other intangibles that
are needed if a fledgling business is
to get off the ground and prosper.
There are two types of franchises.
The simpler version, known as a
"product/trade name franchise," is the
sale of the right to use a business
name or trademark. In the more complex
form, called a "business format
franchise," the fates of the parties
are tied together more closely and for
a longer period of time. In this
format, the franchisee trades some of
its independence in exchange for
various forms of assistance from the
franchisor.
Money Matters
One benefit of a franchise is that
the prospects for a healthy bottom
line are enhanced, since the risks of
the investment are reduced by being
associated with an established company
and its good name. But that boost is
not without cost. A would-be
franchisee should always be aware of
the financial commitment involved, but
not be too quickly scared away by the
reality that here, as in most business
matters, "you have to spend money to
make money."
It is only prudent to consider
carefully a number of likely expenses.
There is the initial franchise fee,
sometimes nonrefundable and usually at
least a few thousand dollars. Costs to
rent or build an outlet and to
purchase the initial inventory will be
significant. The full range of
expenses depends on the type of
business, but some of the other
typical expenses include fees for
licenses and insurance, ongoing
royalty payments to the franchisor
based on income and for the right to
use the franchisor's name, and
payments into the franchisor's
advertising fund.
Who's in Charge Here?
It is the nature of a franchise
that, in exchange for getting to hitch
its wagon to the franchisor, the
franchisee agrees to give up some of
the control over how the business will
operate. There still should be room
for putting a personal stamp on the
business, but the franchise business
model is not for someone who would
have difficulty giving up the
decision-making power that comes with
starting a business. Owners of a "Mom
and Pop" do not need permission for
their store's color schemes, but the
franchisee probably will.
As set out in the franchise
agreement, the franchisor will usually
have the final say about the specific
goods and services that may be sold,
site approval for the business
location, design or appearance
standards, as well as authority over
an array of operational matters such
as hours of operation, signs, employee
uniforms, and even bookkeeping
procedures. On the larger scale, the
franchisor also may limit the
franchisee's business to a specific
territory.
Parting Company
A franchisee's breach of the
franchise agreement, such as by
failure to make payments or to comply
with performance standards, could
result in termination of the franchise
and loss of the franchisee's
investment. Even without a breach, a
franchisee must foresee that franchise
agreements generally run for a finite
period, such as 15 or 20 years. Of
course, if both sides so desire, the
agreement can be renewed under the
same terms or perhaps even terms more
favorable to the now-proven franchise.
But the franchisor could decide not to
renew, and it usually reserves the
right to do so for its own reasons. If
there is a renewal, the parties must
agree again to all of the terms and
conditions. The franchisor may take
that opportunity to make changes in
the deal to its benefit. In that
event, the franchisee would be wise to
give a fresh look at whether owning a
franchise still makes business sense.
Anyone seriously considering buying
and running a franchise needs to do
the homework first, and the Federal
Government has made that process more
organized. The Federal Trade
Commission (www.ftc.gov) requires
franchisors to prepare a disclosure
document, sometimes called a Franchise
Offering Circular, that puts in one
place a wealth of information about
the franchisor, current and former
franchisees, and what the franchisee
is agreeing to when the franchise
agreement is signed. Reading and
understanding the disclosure document,
not to mention the franchise agreement
itself, is essential. One should
always seek independent professional
advice before making a commitment to a
franchise arrangement.
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VETERANS' BENEFITS IMPROVEMENT
ACT
A new federal law has
enhanced the rights of members
of the armed services during
active duty and on their
return to the civilian
workforce. The Veterans'
Benefits Improvement Act makes
two significant additions to
the Uniformed Services
Employment and Reemployment
Rights Act (USERRA). USERRA is
intended to encourage
non-career uniformed service
by balancing the needs of
individuals in those services
with the needs of civilian
employers who also depend on
those same individuals.
Notice Requirement
The first provision
requires that civilian
employers inform employees of
their rights and obligations
under USERRA annually. The
notice requirement may be met
by posting a notice where
employers customarily place
notices for employees. This
part of the new law became
effective on March 10, 2005.
Extension of Benefits
The second change is an
extension of
employer-sponsored health care
from 18 to 24 months,
beginning with the person's
absence from employment
because of duty in the armed
services. USERRA gives the
individual the right to elect
to continue coverage under the
employer's health plan, even
though the coverage otherwise
would end because of the
individual's absence. A
"health plan" encompasses an
employer's health, dental,
vision, and prescription drug
plans, as well as health
reimbursement arrangements and
flexible spending accounts.
The employee, not the
employer, pays for the
coverage during the employee's
absence. This health-care
provision went into effect on
December 10, 2004.
USERRA, the comprehensive
legislation that was changed
only in part by the Veterans'
Benefits Improvement Act, is
far-reaching in its impact, as
it applies to private and
public employers alike,
regardless of size. It is
subject to various conditions
and exceptions that make a
full reading of the law, not
to mention professional
guidance, advisable. USERRA
affects the following areas:
* Reemployment--Employers
must grant military leave for
employees called to active
duty or National Guard or
Reserve training. On their
return, the employees must get
their jobs back or jobs with
comparable seniority, status,
and pay.
* Payroll--USERRA does not
require an employer to
continue to pay employees who
are away on military duty
(though some state laws do).
* Time Off--Employers
cannot force employees to use
vacation and sick days during
military service, but neither
do employers have to let
vacation and sick days
continue to accrue during the
employee's absence. If the
employer awards vacation days
based on length of employment,
the returning employee must
receive vacation time that
would have been given but for
the military service.
* Promotions--Returning
employees "step back on the
escalator," whether it is
going up or down. That is,
they assume the place in the
employer's tenure and
seniority scheme that they
would have had if their
employment had not been
interrupted.
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ENVIRONMENTAL LAW UPDATE
Wetlands Inspection
Paul owned waterfront property that included some tidal wetlands that
were subject to state regulation. When he decided to extend his existing
dock and add another boat lift, he submitted the necessary application to
the state, but he refused to consent to a land-based inspection of the
premises. Nevertheless, following the usual procedure, an inspector went to
the property to make sure that plans submitted with the application
accurately reflected existing conditions and to evaluate the possible impact
of the project on the wetlands.
When the inspector arrived and no one answered the door, she passed
through a gate with a "No Trespassing" sign on it to get into the backyard
that led to the dock area. With a video camera rolling, Paul confronted the
inspector, who identified herself and explained the reason for her visit.
Paul told the inspector that she was trespassing, threatened to have her
arrested if she did not leave immediately, and then escorted her off the
property. The whole encounter took about three minutes.
Paul sued the state inspector for violation of his right not to be
subjected to unreasonable searches or seizures. It is true as a general rule
that an inspection of a private dwelling by a local or state officer,
without either a warrant or the consent of the owner, is unreasonable absent
certain exceptional circumstances. Unfortunately for Paul, his case fell
within one of those exceptions, causing his lawsuit to fail. Under the
"special needs" doctrine applied by the court, a weighing of several factors
can justify a warrantless administrative inspection undertaken as part of a
regulatory scheme.
In Paul's case, he had a diminished expectation of privacy since the
outside areas around his home could be viewed by the public. Paul's privacy
interest was also weakened by his having submitted the application that
prompted the inspection in the first place. The intrusion by the inspector
was minimal and was hardly different from the kind of observation of the
property that anyone could have accomplished from the water behind Paul's
house. The court emphasized that each case would turn on its particular
facts, but in Paul's case the state's interest in regulating construction on
tidal wetlands overrode any expectation of privacy.
No Help for Toxic Waste Cleanup
A company bought an aircraft engine maintenance business and operated the
business for a few years. It then discovered that the property on which the
business was located was contaminated with toxic waste, both because of the
company's activities and the activities of the previous owner. The company
reported itself to a state environmental agency, which told the company that
it was in violation of state laws and directed that the site be cleaned up.
However, neither the state agency nor its federal counterpart, the
Environmental Protection Agency, ever brought a proceeding to force the
cleanup.
Under the state's supervision, the company cleaned up the property
(incurring costs in the millions of dollars) and unsuccessfully sued the
previous owner that had contributed to the contamination, in hopes of
getting a contribution to the cleanup costs as well. This case is a study in
how a few words in a statute can control the outcome in a dispute where
large sums of money are at stake.
The claim for a contribution to the cleanup costs rested on a part of the
federal Comprehensive Environmental Response, Compensation and Liability Act
(CERCLA). That statute states that any person "may" seek contribution from
any other person who is or may be liable under CERCLA, "during or following
any civil action" under CERCLA. The U.S. Supreme Court interpreted the
statutory language as meaning that the company could not seek contribution
from the previous owner (and fellow polluter) because no proceeding under
CERCLA was ever instituted against the company that cleaned up the toxic
waste.
The use of "may" by Congress meant that an action for contribution was
authorized only if the conditions that followed were present,
including a civil action under CERCLA. Appeals by the company based on the
underlying purposes of CERCLA fell on deaf ears before the Court. As the
Court put it, "It is ultimately the provisions of our laws rather than the
principal concerns of our legislators by which we are governed."
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NEW TAX DEPOSIT RULES FOR SMALL BUSINESSES
As of January 1, 2005, the IRS increased the minimum threshold for Federal
Unemployment Tax Act (FUTA) deposits. Under the previous rule, employers were
required to make a quarterly deposit for unemployment taxes if the accumulated
tax exceeded $100. Now the threshold is $500.
The IRS estimates that this change will lighten the load for more than 4
million small businesses. Assuming an employer makes timely state unemployment
tax payments, the most that the IRS will collect from employers per employee
is $56 per year. Before the threshold was increased, most employers with two
or more employees had to make at least one federal tax deposit a year. Now
employers with eight employees or fewer will be freed from the requirement of
making as many as four FUTA deposits per year.
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FAMILY LIMITED PARTNERSHIPS DRAW IRS SCRUTINY
A family limited partnership (FLP), like other limited partnerships, is a
form of business consisting of one general partner and one or more limited
partners. In an FLP, however, the individuals involved usually are members of
different generations of the same family. One of the advantages of a
well-executed FLP is a reduction in federal estate and gift taxes. Instead of
transferring assets directly to beneficiaries, an individual may transfer
interests in a limited partnership. Since interest in an FLP is not marketable
and since a limited partner does not control management of the enterprise, the
value of interests in an FLP usually can be discounted by anywhere from 25% to
50%, with a corresponding reduction in tax liability.
As with many transactions among family members, the IRS has a history of
casting a skeptical eye on FLPs. Essentially, the IRS is intent on assuring
that the tax advantages of any particular FLP are not the be-all and end-all
for its existence. If the FLP is deemed to be a sham, the IRS may challenge
the valuation discount and perhaps even the very existence of the partnership.
In one recent case, a federal appeals court found an FLP to be legitimate
despite some circumstances that had aroused IRS suspicion. A 96-year-old woman
put about $2.5 million into an FLP, keeping $450,000 for her personal
expenses. She died two months later. The fact that the transfer included
interests requiring active management and that no personal assets, such as a
house or car, were involved weighed in favor of the FLP. Also, the person
making the transfer into the FLP did not manage the FLP. Perhaps most
importantly, oil and gas operations provided an essential legitimate business
purpose for the FLP.
In another case that was similar in many respects, including the age of the
individual transferring the assets to the FLP, the assets were found to be
subject to the estate tax because the FLP had not been formed for a valid
business purpose. Transactions made by the FLP never went outside the family
circle and amounted to financing the needs of individual family members.
Emerging from the cases are a few rules of thumb for setting up and running
an FLP so as to realize its tax benefits without attracting the attention of
the IRS:
* Articulate real business reasons for the FLP that can be substantiated by
persons outside the FLP;
* Do not let the person transferring assets into the FLP transfer all of
his or her assets or use the FLP to pay personal expenses;
* Assign control over the FLP to a general partner who is not the same
person who funded the FLP. Often the general partner is an entity, such as a
limited liability company;
* Have some "actively" managed assets in the FLP; and
* Follow the formalities for setting up and operating the FLP, including
separate accounts and scrupulous adherence to formal accounting practices.
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