Franchise tax

What Is Franchise Tax?

A franchise tax is a government levy imposed by some U.S. states on certain business organizations, such as corporations and partnerships, for the privilege of doing business or existing in that state. Unlike an income tax, a franchise tax is typically not based on a company's net income or profits. Instead, it is often calculated based on the business's net worth, capital stock, or a measure of its gross receipts, placing it within the broader category of corporate taxation. The exact calculation and application of the franchise tax vary significantly by state.

History and Origin

The concept of a franchise tax dates back to the 19th century in the United States, emerging as states sought ways to tax burgeoning industries and businesses. Early versions of the tax often targeted specific sectors like railroads and banks. For instance, North Carolina established a franchise tax in 1849, initially based on the capital stock of corporations. By 1901, North Carolina expanded this to include all corporations, moving from a graduated scale to a rate-based system by 1913.²⁸

In Texas, the franchise tax was first enacted in 1893, beginning as a flat annual fee for all corporations operating in the state.²⁷ Over time, the scope and amount of the Texas franchise tax expanded significantly, particularly in response to state revenue needs and shifting economic landscapes.²⁵, ²⁶ States like Delaware also adopted similar taxes, requiring corporations incorporated there to pay a franchise tax for the privilege of their legal existence, regardless of where they conduct business.²⁴

Key Takeaways

• A franchise tax is a state-level levy on businesses for the privilege of operating or being incorporated in that state.
• It is generally not based on net income but often on factors like net worth, capital stock, or gross receipts.
• Many states have either eliminated or significantly reformed their franchise tax laws due to criticisms regarding complexity and economic impact.
• Compliance with franchise tax obligations is crucial for maintaining a business's "good standing" with the state.
• The tax serves as a revenue source for states, often collected annually.

Formula and Calculation

The formula for calculating franchise tax varies considerably by state. Some states, like Delaware, offer multiple calculation methods, such as the Authorized Shares method or the Assumed Par Value Capital Method, with minimum and maximum tax amounts.²², ²³ Other states, such as Texas, base their franchise tax on a business's "margin," which is generally calculated as total annual revenue minus a choice of deductions (e.g., 30% of total revenue, cost of goods sold, or compensation).²¹

For example, a common approach might involve:

Where:

• Taxable Base could be net worth, capital stock, or a defined margin.
• Tax Rate is the percentage or per-unit rate set by the state.

In North Carolina, for instance, the franchise tax historically considered the highest of three amounts: apportioned net worth, 55% of the appraised value of real and tangible personal property, or total actual investment in tangible property.²⁰ However, this has been simplified in recent years to primarily focus on apportioned net worth.¹⁸, ¹⁹

Interpreting the Franchise Tax

Interpreting the franchise tax primarily involves understanding a state's specific regulations and how they apply to a business's legal structure and financial position. Since it's often a "privilege" tax, a company may owe it even if it incurs losses. This distinguishes it from profitability-based taxes.

For businesses, the franchise tax represents an annual cost of maintaining their legal existence or the privilege of operating within a given state's borders. The amount can vary widely based on factors such as the number of authorized shares, total assets, or a calculated margin. Businesses must correctly identify their "nexus" with a state, meaning sufficient connection to be subject to its tax laws, which can be determined by physical presence or economic activity. Accurate calculation and timely payment are essential to avoid penalties and maintain good standing with the state's corporate registry.

Hypothetical Example

Consider a hypothetical startup, "Tech Innovations Inc.," incorporated in Delaware. Delaware requires all C Corporations to pay an annual franchise tax and file an annual report.¹⁷ Tech Innovations Inc. has 10,000 authorized shares of no par value.

Delaware offers two methods for calculating the franchise tax: the Authorized Shares Method and the Assumed Par Value Capital Method. Let's assume Tech Innovations Inc. uses the Authorized Shares Method.

1. Determine the number of authorized shares: 10,000 shares.
2. Refer to Delaware's tax schedule: For corporations with 10,000 shares or less, the minimum tax is $175.¹⁶

In this scenario, Tech Innovations Inc. would owe a minimum of $175 in Delaware franchise tax, plus an annual report filing fee, for the privilege of its corporate existence in Delaware, regardless of whether it generated any revenue or profits in the previous year.¹⁴, ¹⁵ This payment would be due by March 1st.¹³

Practical Applications

Franchise taxes are a recurring compliance obligation for many businesses, particularly corporations and limited liability companies (LLCs). Their practical applications include:

• State Revenue Generation: Franchise taxes contribute to state budgets, funding various public services.
• Business Registration and Maintenance: Paying the franchise tax is often a prerequisite for a business to maintain its active legal status and "good standing" with the state. Failure to pay can lead to penalties or even administrative dissolution.¹² The Texas Comptroller of Public Accounts provides forms and resources for filing the Texas franchise tax.¹⁰, ¹¹
• Location Strategy: Businesses considering where to incorporate or expand operations may analyze a state's franchise tax structure as part of their tax planning and overall cost of doing business. States like Delaware are popular for incorporation despite their franchise tax due to other business-friendly laws.
• Legal Compliance: Companies must diligently track filing deadlines and accurately calculate their franchise tax liability based on the specific laws of each state where they have a tax nexus. The Texas Comptroller's office offers online tools and guidance for filing, including updates for LLCs.⁸, ⁹

Limitations and Criticisms

Despite their role in state revenue, franchise taxes face several criticisms:

• Burden on Businesses: Critics argue that franchise taxes can be particularly burdensome for new businesses, capital-intensive companies, or those experiencing losses, as the tax is often owed regardless of profitability. This can force businesses to dip into valuable cash flow to cover the tax.⁷
• Discouragement of Investment: By taxing net worth or assets rather than income, the franchise tax can discourage in-state investment and asset accumulation, as businesses might choose to grow their net worth in states without such taxes.⁶
• Double Taxation Concerns: In states that impose both a corporate income tax and a franchise tax without allowing businesses to choose the higher of the two, concerns about "double taxation" arise. This is because businesses might be taxed on their income and then again on their assets or privilege to operate, increasing tax burdens and compliance costs.⁴, ⁵
• Complexity: The varied and often intricate calculation methods across different states can create significant compliance challenges for multi-state businesses, leading to high administrative costs.³ The California Franchise Tax Board, for instance, has faced criticism regarding the slow resolution of controversy cases, including audits and refund claims, which can extend over many years.²
• Regressivity: Some argue that franchise taxes can be regressive, disproportionately affecting smaller businesses or those with lower profit margins compared to larger, more established companies.

Franchise Tax vs. Corporate Income Tax

Franchise tax and corporate income tax are both levies on businesses, but they differ fundamentally in their basis:

The main point of confusion arises because both are state-level business taxes. However, the corporate income tax directly targets a company's earnings after deductions, whereas the franchise tax is a separate charge related to the fundamental right or privilege of conducting business within a jurisdiction. Some states, like Texas, have actively debated and sometimes phased out their franchise tax due to its complexity and perceived negative impact on businesses.¹