Franchise Tax

A franchise tax is a fee businesses must pay to a state government for the right to operate or be incorporated in that state. Unlike income tax, it's not based on how much money the business makes but on other factors like its structure, value, number of shares, or capital.

Franchise tax can be a crucial part of doing business in the U.S. It's a fee that companies pay to operate in a state, separate from income tax, and it's calculated based on different factors depending on the state. Businesses need to understand and follow franchise tax rules to avoid penalties and stay in good standing. By considering these taxes in their planning, companies can make better decisions about where to operate and how to manage their finances.

• Annual Payment: Companies usually have to pay this tax every year. Franchise tax increases the overall cost of running a business.
• Different Rules by State: Each state has its own rules for calculating the franchise tax. It can be calculated using different values, such as net worth, capital stock, gross receipts, or even be a flat fee.
• Applies to Various Businesses: Corporations, LLCs, and partnerships might all need to pay franchise tax.
• Requirement: Businesses must follow state franchise tax laws to stay in good standing. Good standing means that the company has done everything required of it by law to operate in that jurisdiction.
• Various Names: May be referred to as a privilege tax in some areas or states.

Think of a franchise tax as a membership fee paid to join a club. States charge businesses this fee for the privilege of operating there. The money collected helps the state pay for things like roads, schools, and public services that everyone, including businesses, uses. Companies must understand and comply with franchise tax laws to avoid penalties and ensure smooth operations. By incorporating franchise tax considerations into their planning, businesses can effectively manage their tax obligations and focus on growth and success.

Who Pays Franchise Taxes?

• Corporations: This includes businesses that are started in the state (domestic) and those from another state but do business in the state (foreign).
• LLCs: Limited Liability Companies operating in the state might have to pay this tax, particularly if they're a large organization.
• Partnerships: Some states also require partnerships to pay franchise tax.

Look up your state's business website and possible franchise tax requirements here.

Who Doesn't Pay Franchise Taxes?

• Some Small Businesses: There might be reductions or exemptions in franchise taxes for small businesses, with states acknowledging that leaner operations benefit from reduced taxes, encouraging overall economic growth.
• Nonprofits & Government: Organizations offering societal benefits and not operating for profit can be exempt from franchise taxes.
• Industries of Need: If the government wants to encourage the growth of specific sectors, like renewable energy, some states may offer franchise tax exemptions.

Different States, Different Rules

Every state handles franchise taxes differently. States with lower franchise taxes or simpler rules are often seen as more friendly to businesses, which can influence where companies decide to set up shop. Delaware, for example, has rules that many businesses find favorable, so many companies choose to incorporate there. Other states might have higher taxes or more complicated rules, like California.

Some notable states with a franchise tax include Delaware (a common state for start-up and corporation incorporation), California (the most populous state), New York (home to multinational conglomerates), and even Texas (the second largest state and doesn’t impose personal income tax).

Kansas, Missouri, Pennsylvania, and West Virginia once had franchise taxes but have dissolved their regulations in recent years. Nevada, another incorporation friendly state, also does not levy a franchise tax.

Franchise Tax Amounts

States have different ways to calculate how much franchise tax a business owes, including:

• Net Worth: Some states look at how much the business is worth.
• Capital Employed: Others consider the amount of money the business is using within the state.
• Number of Shares: The number of shares can affect the tax for corporations.
• Flat Fee: Some states charge a fixed amount no matter what.

Franchise taxes are not income taxes, nor are they taxes paid on franchises, as the name might imply.

How It Affects Businesses

Franchise tax is one of the many costs of running a business. Companies must consider these taxes when planning their budgets and deciding where to do business. Knowing each state's specific rules can help companies to manage their taxes better.

Importance of Compliance

It's essential for businesses to comply with franchise tax requirements to maintain their ability to operate within a state. Non-compliance can lead to significant penalties, including fines and interest on unpaid taxes. In severe cases, the state can revoke the business's right to operate, effectively shutting it down. Therefore, staying informed about the franchise tax requirements in each state where the business operates is critical.

Case Studies - Delaware & Texas Franchise Tax

Delaware is a prime example of a state that has used its franchise tax laws to attract businesses. With its favorable tax structure and efficient incorporation process, Delaware has become the state of choice for many large corporations. Over half of the publicly traded companies in the United States are incorporated in Delaware due to that business-friendly environment.

Texas uses a margin tax, a franchise tax based on a business's revenue. This approach allows Texas to capture tax revenue from a broad base of businesses, ensuring that even companies with slim profit margins contribute to the state's coffers. The margin tax also considers various deductions, making it flexible for businesses of different sizes and structures.

Planning and Strategizing for Franchise Tax

Understanding the franchise tax implications is crucial when starting or expanding a business. Businesses need to account for these taxes in their financial planning and budgeting. It's also important to consider the potential tax burden when choosing a state for incorporation or expansion. For example, a business might decide to incorporate in Delaware for its favorable tax laws but operate in another state with a lower cost of living and operating expenses.