What Is a Franchise Tax?
The term franchise tax refers to a tax paid by certain enterprises that want to do business in some states. Also called a privilege tax, it gives the business the right to be chartered and/or to operate within that state. Companies in some states may also be liable for the tax even if they are chartered in another state. Despite the name, a franchise tax is not a tax on franchises and is separate from federal and state income taxes that must be filed annually.
Key Takeaways
- A franchise tax is a levy paid by certain enterprises that want to do business in some states. Contrary to what the name implies, a franchise tax is not a tax imposed on a franchise.
- Some entities are exempt from franchise taxes including fraternal organizations, nonprofits, and some limited liability corporations.
- Franchise taxes are paid in addition to federal and state income taxes.
- The amount of franchise tax can differ greatly depending on the tax rules within each state and is not calculated on the organization's profit.
- Kansas, Missouri, Pennsylvania, and West Virginia all discontinued their corporate franchise taxes.
Understanding Franchise Taxes
A franchise tax is a state tax levied on certain businesses for the right to exist as a legal entity and to do business within a particular jurisdiction. As of 2020, these states included Alabama, Arkansas, California, Delaware, Georgia, Illinois, Louisiana, Mississippi, New York, North Carolina, Oklahoma, Tennessee, and Texas. Kansas, Missouri, Pennsylvania, and West Virginia all discontinued their corporate franchise taxes.
Contrary to what the name implies, a franchise tax is not a tax imposed on a franchise. Rather, it's charged to corporations, partnerships, and other entities like limited liability corporations (LLCs) that do business within the boundaries of that state. Some entities are exempt from franchise taxes, namely fraternal organizations, nonprofits, and certain LLCs. A more comprehensive list of exemptions is noted below. Companies that do business in multiple states are generally charged a franchise tax in the state in which they are formally registered.
Contrary to what the name implies, a franchise tax is not a tax imposed on a franchise.
Franchise Tax Rates
Franchise taxes do not replace federal and state income taxes, so it's not an income tax. These are levies that are paid in addition to income taxes. They are usually paid annually at the same time other taxes are due. The amount of franchise tax can differ greatly depending on the tax rules within each state. Some states calculate the amount of franchise tax owed based on an entity's assets or net worth, while other states look at the value of a company's capital stock.
Still, other states may charge a flat fee to all businesses operating in their jurisdiction or calculate the tax rate on the company’s gross receipts or paid-in capital.
Delaware Franchise Tax Rates
Depending on the size of the corporation and how it decides to file, Delaware franchise tax rates range from anywhere between $175 to $250,000 annually. Meanwhile, limited partnerships (LP), limited liability companies (LLC), and general partnerships formed in the State of Delaware are only required to pay an annual tax of $300.
California Franchise Tax Rates
Small business taxes in California are layered, with a franchise tax applying in certain situations. For example, the franchise tax does not apply to corporations and LLCs that elect to be treated as corporations. However, California franchise tax rates do apply to S corporations, LLCs, LPs, and limited liability partnerships (LLPs).
In California, the franchise tax rate for S corporations is the greater of either $800 or 1.5% of the corporation's net income. For LLCs, the franchise tax is $800. LLCs that elect to be taxed as a corporation are subject to California's corporate income tax instead of a franchise tax; meanwhile, franchise taxes for LLP and LPs vary but must pay the minimum $800 franchise tax.
A company that does business in multiple states may have to pay franchise taxes in all the states it is formally registered in.
Special Considerations
A company that does business in multiple states may have to pay franchise taxes in all the states it is formally registered in. Sole proprietorships are not usually subject to franchise taxes and other forms of state business income tax, in part because these businesses are not formally registered with the state in which they do business. The following entities are not subject to franchise tax:
- Sole proprietorships (except for single-member LLCs)
- General partnerships when direct ownership is composed entirely of natural persons (except for limited liability partnerships)
- Entities exempt under Tax Code Chapter 171, Subchapter B
- Certain unincorporated passive entities
- Certain grantor trusts, estates of natural persons, and escrows
- Real estate mortgage investment conduits (REMICs) and certain qualified real estate investment trusts (REITs)
- a nonprofit self-insurance trust created under Insurance Code Chapter 2212
- a trust qualified under Internal Revenue Code Section 401(a)
- a trust exempt under Internal Revenue Code Section 501(c)(9)
- unincorporated political committees
Franchise Tax vs. Income Tax
There are some key differences between a franchise and income tax. Unlike state income taxes, franchise taxes are not based on a corporation’s profit. A business entity must file and pay the franchise tax regardless of whether it makes a profit in any given year. State income taxes—and how much is paid—on the other hand, are dependent on how much an organization makes during the year.
Income tax is also applied to all corporations that derive income from sources within the state, even though they may not do business within its boundaries. Doing business may be defined differently by some states as several factors are considered in establishing nexus, including whether the company sells in the state, has employees in the state, or has an actual physical presence in the state.
Delaware is well-known as a tax shelter, especially for corporations that do not conduct business in Delaware. Instead, they have to pay a franchise tax administered by the Delaware Department of State.
Example of a Franchise Tax
As noted above, each state may have a different method of calculating franchise taxes. Let's use Texas as an example. The state's comptroller levies taxes on all entities that do business in the state and requires them to file an Annual Franchise Tax Reportevery year by May 15th. The state calculates its franchise tax based on a company’s margin which is computed in one of four ways:
- Total revenue multiplied by 70%
- Total revenue minus cost of goods sold (COGS)
- Total revenue minus compensation paid to all personnel
- Total revenue minus $1 million
Corporate revenue is calculated by subtracting statutory exclusions from the amount of revenue reported on a corporation's federal income tax return.
What Is the Franchise Tax Board?
The Franchise Tax Board is usually a state-operated tax agency for both personal and business taxes.
Is the Franchise Tax Board the Same as the IRS?
The Franchise Tax Board operates similarly to the IRS, but operates at the state level, rather than the federal. For example, the California Franchise Tax Board states that its mission is to "help taxpayers file tax returns timely, accurately, and pay the correct amount to fund services important to Californians."
When Are Franchise Taxes Due?
Franchise tax deadlines vary by state. In Delaware, the franchise tax deadline is March 1 of each year.
What Happens If You Don’t Pay Your Franchise Tax?
Different states have penalties for late payments of franchise taxes, which the Franchise Tax Board will track and penalize corporations for. In Delaware, the penalty for non-payment or late payment is $200, with an interest of 1.5% per month.
The Bottom Line
Franchise taxes allow corporations to do business within a state, though states have varying tax rates for the corporations based on their legal filing and gross income levels.
