Cold Stone Creamery sued the IRS, saying that it wrongfully demanded payment of debt owed by a former area developer.

Cold Stone Creamery has been the subject of many news reports recently concerning store closures and legal battles with its franchisees, but now the franchisor is waging war against a bigger foe - the Internal Revenue Service.

In February 2008, Cold Stone filed a complaint in Arizona federal court against the U.S. government, claiming the IRS wrongfully levied the assets of its former franchisee/area developer, who Cold Stone had terminated in January 2007 for non-payment and non-compliance. At that time, Cold Stone, in exercising its rights under the franchise and development agreements, took possession of his territories and stores, which led to the IRS levies demanding payment of debt from the franchisor.

Although Cold Stone had been in preliminary settlement discussions with the government, hopeful the issue would be resolved before trial, it was faced with the expiration of a nine-month statute of limitations and had no choice but to file the lawsuit.

The litigation is centered around Sean Brown of SWCS Development Inc., who since November 2000 had been Cold Stone's area developer for Arizona, New Mexico, Texas and Oklahoma. Brown also owned two franchises for opening Cold Stone ice cream shops, executing various franchise and sublease agreements as part of their relationship. AZCS Enterprises operated seven franchises in New Mexico and Arizona and Almacita Enterprises operated five shops in Texas.

In order to assist Brown with pre-opening costs, Cold Stone provided him with loans in 2004 and 2005, totaling $745,509. But according to the franchisor's complaint, Brown's companies failed to pay royalties, rent, advertising fees and other amounts due to Cold Stone, including a promissory note signed by AZCS.

Under Brown's development contract and franchise agreements, Cold Stone had the right to terminate if Brown failed to pay money owed or failed to live up to his contractual obligations. It also gave the franchisor the right to possess his leased property. If terminated for any reason, the franchisee was required to forfeit all fees paid and return all property and materials. After numerous efforts to resolve the issues, Cold Stone terminated Brown and his companies, saying it intended to exercise its right to take possession of each of the opened stores and assume their operations.

During that same time, Brown and his companies were also failing to pay various federal income and employment taxes. The IRS filed federal liens against AZCS in Arizona four times in 2007. The IRS also filed two tax liens in Arizona at the county level in 2007. According to the complaint, all were filed after Cold Stone terminated AZCS and SWCS, and had perfected security interest in, and had taken possession of, the Arizona stores, with the exception of the lien dated January 4, 2007.

But when the government served Cold Stone with a Notice of Intent to Levy in May 2007, with respect to any assets belonging to AZCS, Almacita and SWCS; the franchisor petitioned the court to issue an order declaring the levy invalid, wrongful and unenforceable, and asked for an injunction to prohibit the seizure and sale of the properties.

U.S. Attorney responds

In response to Cold Stone's complaint for wrongful levy, the U.S. Attorney filed its answer and counterclaim on July 3. The government denied that all federal tax liens filed in Arizona, with the exception of the one dated January 4, 2007, were filed after Cold Stone issued the termination letter to its area developer/franchisee.

The counterclaim argued that the Secretary of the Treasury assessed unpaid employer's quarterly federal taxes and unemployment taxes against Almacita for parts of 2005, 2006 and 2007, a total of $119,643. It assessed the same for AZCS for a total of $229,454, and for SWCS for a total of $149,458.

The U.S. Attorney also said that Cold Stone didn't pay its delinquent taxes after receiving a final demand for payment on Aug. 2, 2007, and that it was therefore liable for $498,555, due through April 1, 2008, plus costs and interests. The IRS asked the court to dismiss Cold Stone's complaint and enforce the levies.

Consequently, the U.S. Attorney considered the IRS's interest in the stores "senior" to that of Cold Stone. In addition, the government determined that the market value of the stores was over $1.6 million.

On Sept. 5, 2008, Cold Stone filed a motion to dismiss the government's counterclaim, emphasizing the fact that the IRS's interests in the franchise agreements are baseless and not subject to execution or attachment as a matter of law. The government has until October 20 to respond to the motion.

IRS case could have far-reaching effects

Becker said, "We are doing everything we can to keep that process as short and sweet as possible, as we do with every piece of litigation that we are involved with." When asked if the litigation against the government was listed in Cold Stone's 2008 Franchise Disclosure Documents, he said no. "Based upon my reading of the NASAA guidelines it does not need to be in the FDD."

According to Becker, Cold Stone has not had any disputes or litigation with Sean Brown, since he was terminated in January 2007. He said that Brown and his attorney were aware of the recent IRS litigation since the tax obligations that created the tax levies and litigation are his.

Becker believes this case will interest franchisors and franchisees. He said the IRS asserting a security interest in the development right of a franchisor is novel, but contrary to most of their experiences. He says the IRS can't do that. "I think the Department of Justice is starting to realize that," he said, suggesting that settlement discussions were still in process.

If the IRS should prevail in this litigation, Becker feels it could have a far-reaching effect on the franchise community. "Without question, if the judge rules for the IRS it could set a precedent for franchisors."

Janet Sparks is the former publisher of Continental Franchise Review, an industry newsletter that covered the franchise community for more than 30 years before being acquired by Franchise Times Corporation. Janet can be reached at 303-799-7398

or at [email protected]