Franchise Tax Definition

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Franchise Tax Definition

What Is a Franchise Tax?

The word franchise tax refers to a charge paid by some businesses that want to do business in particular states. It is also known as a privilege tax since it grants the firm the right to be chartered and/or operate inside that state. Companies in certain states may be subject to the tax even if they are incorporated in another state. A franchise tax, according to its name, is not a tax on franchises and is distinct from federal and state income taxes, which must be reported yearly.

Key Takeaways

  • A franchise tax is a fee levied on certain businesses that seek to conduct business in particular states. A franchise tax, contrary to its name, is not a tax levied on a franchise.
  • Fraternal organizations, NGOs, and certain limited liability companies are free from franchise taxes.
  • In addition to federal and state income taxes, franchise taxes must be paid.
  • The amount of franchise tax varies widely depending on state tax regulations and is not based on the organization’s earnings.
  • Corporate franchise taxes were repealed in Kansas, Missouri, Pennsylvania, and West Virginia.

Understanding Franchise Taxes

A franchise tax is a state tax placed on certain enterprises in exchange for the ability to exist as a legal organization and conduct business in a specific jurisdiction. Alabama, Arkansas, California, Delaware, Georgia, Illinois, Louisiana, Mississippi, New York, North Carolina, Oklahoma, Tennessee, and Texas were among these states as of 2020. Corporate franchise taxes were repealed in Kansas, Missouri, Pennsylvania, and West Virginia.

A franchise tax, contrary to its name, is not a tax levied on a franchise. It is instead levied on companies, partnerships, and other organizations such as limited liability corporations (LLCs) that do business inside the state’s borders. Fraternal groups, charitable organizations, and some LLCs are free from franchise taxes. A more complete list of exclusions is provided below. Companies that do business in more than one state are usually subject to a franchise tax in the state where they are legally registered.

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A franchise tax, contrary to its name, is not a tax levied on a franchise.

Franchise Tax Rates

It is not an income tax since franchise taxes do not replace federal and state income taxes. These are additional levies paid in addition to income taxes. They are often paid yearly at the same time as other taxes. The amount of franchise tax levied varies substantially based on the tax laws of each state. Some jurisdictions base the amount of franchise tax owing on an entity’s assets or net worth, while others use the value of a company’s capital stock.

Other states, however, may levy a flat fee on all enterprises operating inside its borders or base the tax rate on the company’s gross revenues or paid-in capital.

Delaware Franchise Tax Rates

Delaware franchise tax rates vary from $175 to $250,000 per year, depending on the size of the business and how it chooses to file. Meanwhile, in the state of Delaware, limited partnerships (LP), limited liability corporations (LLC), and general partnerships are only obliged to pay a $300 yearly tax.

California Franchise Tax Rates

In California, small company taxes are tiered, with a franchise tax applied in specific circumstances. The franchise tax, for example, does not apply to corporations and limited liability companies that prefer to be recognized as corporations. S companies, LLCs, LPs, and limited liability partnerships, on the other hand, are subject to California franchise tax rates (LLPs).

The franchise tax rate for S companies in California is the greater of $800 or 1.5% of the corporation’s net revenue. The franchise tax for LLCs is $800. LLCs that opt to be taxed as corporations are liable to California’s corporate income tax rather than a franchise tax; nonetheless, LLP and LP franchise charges vary but must pay the least $800 franchise tax.

A firm that does business in many jurisdictions may be required to pay franchise taxes in each state where it is legally registered.

Special Considerations

A firm that does business in many jurisdictions may be required to pay franchise taxes in each state where it is legally registered. Because sole proprietorships are not legally registered with the state in which they operate, they are not normally liable to franchise taxes and other kinds of state business income tax. The following entities are exempt from franchise tax:

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  • Single-person businesses (except for single-member LLCs)
  • When the direct ownership is wholly made up of natural people, general partnerships are formed (except for limited liability partnerships)
  • Entities exempt under Tax Code Section 171, Subsection B
  • Certain passive unincorporated entities
  • Certain grantor trusts, natural person estates, and escrows
  • REMICs (real estate mortgage investment conduits) and qualified real estate investment trusts (REITs)
  • a charitable self-insurance trust established under Insurance Code Chapter 2212
  • a trust that meets the requirements of Internal Revenue Code Section 401 (a)
  • a trust exempt under Section 501(c) of the Internal Revenue Code (9)
  • unincorporated political groups

Franchise Tax vs. Income Tax

There are several significant distinctions between a franchise and income tax. Franchise taxes, unlike state income taxes, are not dependent on a corporation’s earnings. Whether or not a company entity generates a profit in any given year, it must submit and pay the franchise tax. State income taxes, on the other hand, are based on how much money an organization produces throughout the year.

Money tax is also levied on all companies that obtain income from sources inside the state, even if they do not do business there. Some states define doing business differently because numerous variables are examined when establishing nexus, such as whether the corporation sells in the state, employs employees in the state, or has an actual physical presence in the state.

Delaware is well-known as a tax haven, particularly for firms that do not do business there. Instead, businesses must pay a franchise tax to the Delaware Department of State.

Example of a Franchise Tax

As previously stated, each state may have its own way of determining franchise taxes. As an example, consider Texas. The state comptroller imposes taxes on all organizations doing business in the state and requires them to submit an Annual Franchise Tax Report by May 15th of each year. The state bases its franchise tax on a company’s margin, which may be calculated in one of four ways:

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  • 70% of total revenue multiplied
  • Revenue less cost of goods sold (COGS)
  • Total income less total employee pay
  • Total revenue minus $1 million

Corporate revenue is determined by deducting statutory exclusions from the revenue reported on a corporation’s federal income tax return.

What Is the Franchise Tax Board?

The Franchise Tax Board is a state-run tax organization that collects both personal and company taxes.

Is the Franchise Tax Board the Same as the IRS?

The Franchise Tax Board functions similarly to the IRS, but at the state rather than federal level. The California Franchise Tax Board, for example, declares that its objective is to “assist taxpayers in filing tax returns on time, properly, and in paying the right amount to finance services vital to Californians.”

When Are Franchise Taxes Due?

Franchise tax dates differ from state to state. The franchise tax deadline in Delaware is March 1 of each year.

What Happens If You Don’t Pay Your Franchise Tax?

Different states impose penalties for late franchise tax payments, which the Franchise Tax Board will monitor and punish firms for. In Delaware, the penalty for nonpayment or late payment is $200, plus 1.5% per month interest.

The Bottom Line

Franchise taxes enable businesses to do business inside a state, albeit states have different tax rates for corporations depending on their legal status and gross revenue levels.

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