Franchisee or Employee Debate Lives On

There is a long-standing academic debate regarding: independent contractor or employee? A newer debate is stirring: Franchisee or employee? And, while by their definition they seem distinct, state and federal agencies, as well courts around the United States, are weighing in on the issue to the detriment and confusion of franchisors and franchisees throughout the country.

As an initial matter, from a legal perspective, the definition of “employee” is determined by Federal law (Fair Labor Standards Act, Internal Revenue Code, for example) and state law (Wage and hours laws, for example). If in fact an individual is covered under a specific employment law they may be entitled to certain rights and protections. For example, under the Fair Labor Standards Act, certain employees are entitled to minimum wage or other benefits, and other laws address health insurance or pension.

There are myriad cases in the legal world where a licensee has filed a lawsuit against a trademark holder for failing to comply with franchise regulations. In those cases, whether intentional or accidental, the court must analyze the nature of the relationship, regardless of how the parties’ contract reads or what the parties intended the relationship to be, i.e. “a franchise”. Similarly, in the employment context, courts or governmental agencies look to the tests under the law to determine if an individual is actually an employee, despite the classification between the parties. So too can the analysis be done when examining whether a franchisee is actually an employee.

In this regard, there is an increased scrutiny over franchise relationships, especially by state and federal taxing authorities, relating to whether franchisees are actually employees in particular industries. The question of whether someone can be both occasionally yields an affirmative conclusion making it all the more confusing. Franchise companies are easy targets for taxing authorities that, at the end of the day, have a goal of increasing (presumably appropriately) revenues generated through taxation. This is especially so now considering the high level of bankrupt or financially depressed jurisdictions around the country. As such, and for example, state agencies have gone after franchise companies to determine that their franchisees are actually employees in an effort to collect back and future taxes. The analysis, in its simplest form, comes down to control. The analysis done by a court or a governmental agency focuses on the nature of the relationship: does the individual have set hours, can they hire and fire, does the “employee” they have delineated tasks? In so analyzing, the intent of the parties is basically irrelevant.

Franchisors that exert substantial control, beyond the “normal” level of control over system standards and brand expansion, open themselves to scrutiny by the government and potential litigation. From a business perspective, while not advisable, there are benefits to misclassifying franchisees that truly serve as employees. This allows franchisors to avoid paying wages in many instances, and numerous taxes related to having a work force. More importantly for franchisors, in a franchise relationship, the financial burden and risk of operating a particular unit falls squarely on the franchisee – thus, shifting that burden to the employee in the employment context, which is atypical of employment relationship.

The situation where a franchisor can cross the line to employer is not found in many franchise relationships despite the substantial exertion of control and monitoring of the franchisees. However, franchisors can very easily cross the line by going too far. For example, some franchisors claim they “own” the franchisee’s customers; some control the temperature and radio volume in the store; some franchisors collect all the fees and pay a commission to the franchisee – these taken individually may not result in a conclusion of “employee”, but taking the plethora of controls and inserting them in one system can result in a crossing of the line.

Franchisees should be aware of these concerns for many reasons. First, in protecting from termination or changes to the system there are certain rights employees have that franchisees would not. Moreover, from a financial perspective, there are also obligations employers have, i.e. minimum wage, which would also benefit the franchisee/employee in certain systems.

As always, the debate between legal scholars shall certainly persist, but as more government agencies explore franchise companies, and as more franchisees challenge the nature of their franchise relationship in court, it will continue to take shape. Either way, this is an issue for both franchisors and franchisees to consider in forming their relationship and in carrying out their duties and responsibilities to one another.