When you think of a franchise, famous brands like McDonald’s, Ace Hardware, or Hilton Hotels may come to mind. But you may be surprised to learn that even if your business isn’t franchised, your state can still impose a franchise tax on it.
What is a franchise tax?
You’re probably wondering how your business can be liable for the same tax as a popular fast-food franchise. Despite its misleading name, the state franchise tax is not levied strictly on franchised businesses. In fact, most corporations, partnerships, and limited liability companies (LLCs) are subject to it.
Franchise tax is a business tax charged by many states or cities for the privilege of doing business within their borders. It’s often referred to as a “privilege tax” for this very reason.
Franchise tax requirements vary widely, and not all states levy them. There are also many entities that aren’t even subject to franchise taxes. We’ll clarify these situations later in this article.
Franchise tax vs. income tax
Even though they are generally due around the same time of year, franchise taxes don’t replace federal or state income taxes.
State and federal income tax is based on the business’s profits, while the franchise tax is based on income or levied as a flat fee. Whether you make a profit, break even, or lose money, you are still required to pay the franchise tax in the state in which you do business, while with income tax if your business doesn’t realize a profit, you have no business tax liability.
Franchise taxes can also vary widely as states and cities set their own rates, and apply their own criteria such as the business’s size, type, and assets. With income tax, the same tax bracket ranges apply to every business and individual taxpayer…
Further reading: How Do You File Business Taxes?
Who has to pay franchise taxes?
If your business is registered with the state, you may be required to pay an annual franchise tax. However, if you conduct your business under your own legal name and the business isn’t a distinct legal entity, you don’t need to be registered, eliminating the franchise fee liability.
For example, if your business is called “Jim’s Music Store,” the name must be registered with the state. However, if your name is Jim Smith and you open the “Jim Smith Store,” you won’t need to register the name. This would free you from the franchise tax obligation.
If you’re unsure if your business needs to be registered with the state, you can check the U.S. Small Business Administration website for more information.
How nexus determines franchise tax
Franchise taxes are based on a concept called “nexus,” which describes the level of connection between the state and the business. Nexus with a state is established if the business sells goods or services in the state, has employees in the state, and has a physical location in the state. The collection of the state’s sales tax or online sales are other conditions that may also qualify as a nexus.
You don’t need to have a physical presence in a state to be liable for franchise taxes. Simply shipping merchandise to customers in other states may subject your business to the franchise tax. If you conduct business in multiple states, it’s best to consult a tax professional to clarify your franchise tax liabilities in those locations.
Further reading: Sales Tax Nexus: A Simple Guide
Business entities that are not liable for franchise tax
The following businesses are not formally registered within the states that they conduct business. As a result, they are not required to pay a franchise tax.
Sole proprietorship businesses (except for single-member LLCs)
Non-corporate general partnerships, except for LLCs
Entities with an exemption under Tax Code Chapter 171, Subchapter B under the Texas Tax Code
Certain unincorporated passive entities
Grantor trusts, estates, and escrows
Real estate mortgage investment conduits (REMICs) and qualified real estate development trusts
Nonprofit self-insurance trusts under IRS Code Section 401 (a)
Trusts exempt under IRS code 501©(9)
Unincorporated political committees
What states have a franchise tax?
The collection of franchise taxes is usually overseen by the state comptroller’s office or a franchise tax board in each state. As of 2020, the following states require businesses to pay a franchise tax:
- New York
- North Carolina
Kansas, Missouri, Pennsylvania, and West Virginia once had corporate franchise tax but have since discontinued it.
How is franchise tax calculated in each state?
While franchise tax is a flat rate in some states, others use a complex formula to calculate the amount due based on the following criteria:
- Value of stock, shares of stock, capital stock, or authorized shares
- Gross assets
- A specific amount of assets
- Tangible property or assets
- Taxable capital
- Paid-in capital
- Net worth
- Assessed value of real and tangible personal property or net investment in tangible personal property
- Gross receipts
Other states may use their own calculators or other computations to arrive at the franchise tax amount. Here are some examples of how states levy this tax in different ways:
Delaware’s franchise tax is calculated by using the Authorized Shares or Assumed Par Value Capital method. The state allows you to use the method that results in the least tax owed.
Calculating franchise tax in New York requires completion of the corporate tax Form CT-3. Though this tax averages around 6.5% of business income earned in the state, three different amounts are required to arrive at this figure. These are your taxes on business income, capital, and your fixed dollar minimum tax.
Texas uses an EZ Computation Report for businesses with annualized total revenue of $20 million or less. Otherwise, the tax is determined by the business’s taxable margin using the total revenue multiplied by 70%, total revenue minus cost of goods sold, total revenue minus compensation paid to all personnel, or total revenue minus $1 million.
California’s franchise tax for S corps is 1.5% of their net income or $800, whichever amount is higher. Franchise taxes for LLCs, however, are based on net income and range from $800 for net income of less than $250,000 to $11.790 for net income of $5 million and higher.
As you can see, each state’s method of computing franchise taxes can greatly differ. For this reason, it’s essential that you check your state’s Department of Revenue website for your franchise tax rate and any other additional requirements.
When are franchise taxes due?
Franchise taxes are levied yearly with varying deadlines. The due date may also depend on the type of business. For example, in Delaware, corporations must pay their franchise taxes by March 1st, while LLCs have until June 1st to pay their taxes.
Some states have due dates on the 15th of the third or fourth tax year month. In other instances, the due date may be the anniversary of the day the business was formed, which makes it the same date each year.
Since each state has its own franchise tax deadlines, check your state’s Department of Revenue website for payment deadlines.
What happens if you don’t pay?
As is the case with nonpayment of any government taxes, your business could face consequences for not paying a state-mandated franchise tax.
A corporation that holds a certificate of good standing with the state to prove legal compliance can have this status removed if they don’t stay current with their franchise taxes. This could jeopardize future business transactions and revoke the right to enforce contracts in the state.
States also impose financial penalties and fees for not filing franchise taxes. In Delaware, for example, those that fail to pay the tax incur a $200 penalty plus 1.5% in monthly interest on the combination of penalties and the unpaid taxes. In Texas, businesses are penalized $50 and a 5% penalty on taxes filed 1-30 days late or a 10% penalty on taxes that are over 30 days late.
Check with your state’s business taxation website for more information on payment penalties.
How Bench can help
Along with federal, state, and other local taxes, the franchise tax adds another legal financial responsibility to your business. With multiple agencies to file with, keeping track of all the tax laws and any changes can be overwhelming. Franchise taxes can be especially challenging to calculate since the rate varies from state to state.
When Bench files your taxes, we include state income and franchise tax filings at no extra cost. Plus, you’ll have peace of mind that your financials are being handled by our team of experienced and knowledgeable tax professionals. Learn more about how Bench can help with your small business taxes.
Does your business need to pay a franchise tax?
If your business is a corporation, LLC, or partnership registered in a state, you may be required to pay a yearly franchise tax. The amount of the tax can widely vary depending on how it’s calculated. Some states base the amount owed on the business’s net worth, total revenue, or income. Since each state has different tax laws, it’s important to check with your state’s Department of Revenue for more information.