Franchise Tax: Definition, Rates, Exemptions, and Example

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.

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.

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.

State Vs. Federal Franchise Taxes

One fundamental distinction that businesses must understand is the difference between state and federal franchise taxes. The most apparent difference between state and federal franchise taxes lies in their jurisdictional scope. State franchise taxes are levied by individual states, meaning each state has its own set of rules, rates, and requirements. In contrast, federal franchise taxes fall under the purview of the federal government and are uniform across all states.

While both state and federal franchise taxes serve to generate revenue for the government, they have somewhat different purposes. State franchise taxes primarily fund state government operations and services, such as infrastructure projects, education, and healthcare. Federal franchise taxes contribute to funding the operations of the federal government, including national defense, social programs, and public services at the federal level.

Another difference lies in the tax base used to calculate state and federal franchise taxes. As you’ve seen in this article, state franchise taxes often vary in their calculation. Each state takes in different considerations for their rate. Federal franchise taxes, however, typically focus on income and are based on a business's taxable income as determined by federal tax laws. Because there is only one Federal government, there is only one methodology here.

Last, compliance with state and federal franchise tax obligations are similar but still differ. Businesses must adhere to the filing deadlines and requirements established by each state where they conduct business to fulfill their state franchise tax obligations. Alternatively, Federal tax compliance means following the regulations and deadlines set forth by the Internal Revenue Service.

Franchise Tax Exemptions

Franchise tax exemptions provide relief for certain businesses from the obligation to pay franchise taxes. One common exemption criterion is based on business size, with many jurisdictions offering exemptions or reduced tax rates for small businesses. These exemptions may be determined by factors such as annual revenue, total assets, or number of employees, aiming to alleviate the tax burden on startups and smaller enterprises, fostering entrepreneurship and economic growth.

Certain types of businesses or entities may qualify for specific franchise tax exemptions based on their organizational structure or purpose as well. Nonprofit organizations are often exempt from franchise taxes as they operate for charitable, educational, or religious purposes rather than for-profit motives. Similarly, governmental entities and certain types of cooperatives may also be eligible for exemptions from franchise taxes. As an incentive for offering services that benefit society, taxing authorities may offer a financial incentive via a tax exemption. 

Additionally, jurisdictions may offer franchise tax exemptions for businesses engaged in particular industries or activities deemed beneficial to the economy or society. Note that this extends beyond the types of companies talked about in the last paragraph. For example, these exemptions are often designed to incentivize investment in specific sectors such as renewable energy, manufacturing, or research and development. Governments aim to stimulate innovation, job creation, and overall economic development, so they may be willing to offer financial benefits in exchange for a focus in these areas. 

Consequences of Not Paying Franchise Taxes

The consequences of not paying franchise taxes can be significant for businesses. Governing bodies will often impose financial penalties which can accrue over time as long as unpaid taxes hang out unpaid. 

Failure to pay franchise taxes can damage a business's credit rating and reputation, making it more challenging to secure financing or conduct business transactions in the future. As the company attempts to work with others and has to undergo credit checks, pending franchise taxes may disrupt its ability to secure credit lines or financing alternatives.

In addition to financial penalties, businesses that fail to pay franchise taxes may face legal consequences, including the possibility of having their business licenses revoked or suspended. Many jurisdictions require businesses to be in good standing regarding their tax obligations to maintain their legal authority to operate. Therefore, not paying franchise taxes could jeopardize whether or not a business can even operate.

Persistent non-compliance with franchise tax obligations can escalate the severity of consequences, eventually leading to more drastic measures such as tax liens or levies. Tax liens give taxing authorities a legal claim on a business's assets as collateral for unpaid taxes, potentially resulting in the seizure or sale of property to satisfy the tax debt. For example, the government may place a lien on company assets. The government may then sell those assets to raise money that are used in part to pay off the franchise taxes. While this means the franchise taxes (and accrued penalties) are now paid, it also means the business could be disrupted. For example, consider if the only company car was seized and sold during this process.

Franchise Taxes and Tax Planning Strategies

A company can take certain steps to be more strategic about the franchise taxes it pays. One strategy is to optimize the business's legal structure to take advantage of favorable tax treatment. For example, businesses may consider structuring as a pass-through entity, such as a limited liability company or a partnership. This makes it so the company can avoid double taxation at both the entity and individual levels. 

Businesses can also strategically manage their taxable assets and liabilities to reduce their franchise tax burden. This can involve careful consideration of factors such as asset valuation methods, inventory management practices, and debt financing arrangements. The goal here is to be mindful of what items account for the company’s taxable net worth or capital base. By minimizing this, the company can save on taxes. 

Businesses may also be able to get deductions, credits, and exemptions to lower their franchise tax position. This can include leveraging deductions for business expenses such as rent, utilities, salaries, and supplies. Companies may also be able to get credits for the economic activity items mentioned above; since the government may want companies to do these activities, there may be relevant credits related to such as research and development, job creation, or environmental conservation. 

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 (with an example citation to the Texas comptroller office):

• 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 Report every 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.

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.