Small Business

Franchise Tax

What is a franchise tax?

The term franchise tax refers to taxes paid by certain businesses that want to do business in certain states. Also known as a privilege tax, it gives a business the right to license and/or operate in the state. Companies in some states may be subject to taxes even if they are chartered in another state. Despite the name, a franchise tax is not a franchise tax and is separate from federal and state income taxes that must be filed annually.

key takeaways

  • Franchise tax is a tax paid by certain businesses that want to do business in certain states. Contrary to what the name implies, a franchise tax is not a tax levied on franchises.
  • Some entities are exempt from the franchise tax, including fraternal organizations, nonprofit organizations, and some LLCs.
  • In addition to federal and state income tax, there is also a franchise tax.
  • The amount of franchise tax can vary widely based on each state’s tax rules and is not calculated based on the organization’s profits.
  • Kansas, Missouri, Pennsylvania and West Virginia have all stopped corporate franchise taxes.

Understanding Franchise Tax

Franchise tax is a state tax levied on certain businesses for the right to exist as a legal entity and conduct business in a particular jurisdiction. As of 2020, these states include Alabama, Arkansas, California, Delaware, Georgia, Illinois, Louisiana, Mississippi, New York, North Carolina, Oklahoma, Tennessee state and Texas. Kansas, Missouri, Pennsylvania and West Virginia have all stopped corporate franchise taxes.

Contrary to what the name implies, a franchise tax is not a tax levied on franchises. Instead, it charges corporations, partnerships and other entities such as limited liability companies (LLCs) that do business within the state’s borders. Some entities are exempt from franchise tax, namely sibling organizations, nonprofit organizations, and certain LLCs. A more comprehensive list of exemptions is listed below. Companies that do business in multiple states typically pay franchise taxes in the state in which they are officially registered.

Contrary to what the name implies, a franchise tax is not a tax levied on franchises.

Franchise Tax Rate

The franchise tax does not replace federal and state income tax, so it is not an income tax. These are taxes paid in addition to income tax. They are usually paid at the same time as other taxes are paid each year. The amount of the franchise tax can vary widely depending on each state’s tax rules. Some states calculate the amount of franchise tax owed based on an entity’s assets or net worth, while others look at the value of a company’s equity capital. Still, other states may charge a flat fee to all businesses operating within their jurisdiction, or calculate the tax rate on the company’s gross income or paid-up capital.

Delaware franchise tax rate

The franchise tax rate in Delaware ranges from $175 to $250,000 per year, depending on the size of the company and how it decides to file. Meanwhile, limited partnerships (LPs), limited liability companies (LLCs), and general partnerships established in Delaware pay as little as $300 per year in tax.

California Franchise Tax Rate

Small business taxes in California are tiered, and in some cases a franchise tax applies. For example, franchise taxes do not apply to corporations and LLCs that elect to be treated as corporations. However, the California franchise tax rate does apply to S corporations, LLCs, LLCs, and Limited Liability Partnerships (LLPs).

In California, the franchise tax rate for an S corporation is the higher of $800 or 1.5% of the corporation’s net income. For LLCs, the franchise tax is $800. LLCs that elect to be taxed as corporations are subject to California’s corporate income tax, not the franchise tax; meanwhile, LLPs and LPs have different franchise taxes, but must pay a minimum franchise tax of $800.

special attention items

Companies that do business in multiple states may have to pay franchise taxes in all states in which they are duly registered.

Companies that do business in multiple states may have to pay franchise taxes in all states in which they are duly registered. Sole proprietorships are generally not subject to franchise tax and other forms of state corporate income tax, in part because these businesses are not officially registered in the state in which they do business. The following entities are exempt from franchise tax:

  • Sole proprietorship (other than a single-member LLC)
  • A general partnership (except a limited liability partnership) in which the direct ownership consists entirely of natural persons
  • Entities exempt from taxation under subchapter B of chapter 171 of the tax code
  • certain unincorporated passive entities
  • Certain Grantor Trusts, Estates and Trusts of Natural Persons
  • Real Estate Mortgage Investment Channels (REMICs) and Certain Qualified Real Estate Investment Trusts (REITs)
  • Not-for-profit self-insured trust created under Insurance Act Chapter 2212
  • Trusts under Section 401(a) of the Internal Revenue Code
  • Trusts exempted under Section 501(c)(9) of the Internal Revenue Code
  • unincorporated political committee

Franchise Tax and Income Tax

There are some key differences between franchise tax and income tax. Unlike state income taxes, franchise taxes are not based on a corporation’s profits. Business entities are required to declare and pay franchise tax regardless of whether they are profitable or not in any given year. On the other hand, state income taxes — and how much they pay — depend on how much an organization earns during the year.

Income tax also applies to all corporations that derive income from within the state, even though they may not conduct business within the state. Certain states may define doing business differently because several factors are considered when establishing a connection, including whether the company sells in the state, has employees in the state, or has a physical presence in the state.

Delaware is known as a tax haven, especially for companies that do not do business in Delaware. Instead, they must pay a franchise tax administered by the Delaware State Department.

Franchise Tax Example

As mentioned above, each state may have a different method of calculating franchise tax. Let’s take Texas as an example. The state’s auditor general taxes all entities doing business in the state and requires them to file an annual franchise tax report by May 15 each year. The state calculates its franchise tax based on a company’s profit margin, which is calculated in one of four ways:

  • Total revenue multiplied by 70%
  • Gross revenue minus cost of goods sold (COGS)
  • Gross revenue minus compensation paid to all personnel
  • Gross revenue minus $1 million

Corporate income is calculated by subtracting statutory exclusions from the amount of income reported on the corporation’s federal income tax return.

Franchise Tax FAQs

What is the Franchise Tax Council?

Franchise tax boards are generally state-run tax authorities for personal and business taxes.

Is the Franchise Tax Board the same as the IRS?

The Franchise Tax Board operates like the IRS, but operates at the state rather than federal level. For example, the California Franchise Tax Board states its mission is “to help taxpayers file their tax returns in a timely and accurate manner and pay the correct amount to fund services that are important to Californians.”

When does the franchise tax expire?

Franchise tax deadlines vary by state. In Delaware, the franchise tax deadline is March 1 of each year.

What if you don’t pay franchise tax?

Different states have penalties for late payment of franchise taxes, and the Franchise Tax Board will track and penalize companies. In Delaware, the penalty for non-payment or late payment is $200 and interest is 1.5% per month.

bottom line

Franchise taxes allow companies to do business within a state, although states tax companies differently based on their legal filings and gross income level.

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