A Manatt for Entrepreneurs Resource
What is a franchise tax?
A franchise tax is an annual tax a business entity is required to pay in a given jurisdiction as a result of being formed or organized, or for doing business, in that jurisdiction. In Delaware, the franchise tax is a “privilege fee,” which allows an entity to maintain its good-standing status in Delaware. This is a separate and distinct tax and has no bearing on an entity’s income or operations. Payment of the franchise tax on time and in the correct amount is important to maintain good-standing status in Delaware. Failure to pay on time can result in penalty fees (including interest) and could expose an entity’s owner to personal liability if they continue to operate the business. Importantly, a quick search of the Internet will reveal myriad stories about companies that have failed to timely pay the franchise tax and file their annual report, and that then receive tax bills from Delaware claiming that the companies owe thousands of dollars in taxes to the state. Many of these situations can be rectified, but companies ought to take steps to avoid these problems in the first place.
In Delaware, the franchise tax for corporations, limited liability companies (LLCs), limited partnerships (LPs) and general partnerships (GPs) is due once a year on a particular date. The deadline for domestic corporations is March 1, and the deadline for all domestic and foreign LLCs, LPs and GPs is June 1.
Along with paying their annual franchise tax, domestic corporations must file an annual report and pay an additional filing fee of $50. The contents of the annual report are summarized below. With respect to foreign corporations registered in Delaware, the corporation must file its annual report by June 30 and pay a $125 flat fee.
The annual franchise tax for domestic and foreign LLCs, LPs and GPs is a $300 flat fee. There is no annual report filing requirement for domestic and foreign LLCs, LPs and GPs.
How do you calculate the franchise tax for a domestic corporation?
There are two methods for calculating the Delaware annual franchise tax for a domestic corporation: (1) the Authorized Shares Method and (2) the Assumed Par Value Capital Method. The difference is important for a few reasons: First, as eluded to above, if a corporation fails to timely pay its tax and file its annual report, Delaware defaults to calculating the taxes owing using the Authorized Shares Method, which may result in the greater amount of taxes owing. Second, because each method takes into account various aspects of a corporation’s share capitalization, ensuring that the corporation is incorporated with a sufficient number of shares and corresponding par value is vital to ensuring a proper tax calculation. Third, Delaware allows corporations to choose the method that results in the least amount of taxes owing, thus incentivizing corporations to timely pay their taxes.
1. Authorized Shares Method
This method uses the number of authorized shares of a corporation to determine franchise tax liability. The number of authorized shares is included in the corporation’s certificate of incorporation. The calculation is as follows:
- 5,000 shares or less (minimum tax): $175
- 5,001–10,000 shares: $250
- Each additional 10,000 shares or portion thereof: add $85
Under this method, the lowest possible franchise tax is $175.
2. Assumed Par Value Capital Method
This method requires the corporation to provide the total number of issued shares and the total gross assets for the corporation’s fiscal year ending the calendar year of the annual report. The total gross assets are the “total assets” reported on U.S. Form 1120, Schedule L, of the corporation’s federal tax return. Under the Assumed Par Value Capital Method, the minimum franchise tax is $400.
The Assumed Par Value Capital Method involves a complex calculation that is beyond the scope of this article. The Delaware Secretary of State’s website includes an example and a detailed explanation of how to calculate the franchise tax using this method (see link below). The website also includes a franchise tax calculator (in the form of an Excel spreadsheet) that can be used to estimate your taxes.
Here is the link to the website.
Which method should I use to calculate the franchise tax? Should I authorize a low number of shares when forming my corporation so I can use the Authorized Shares Method?
Delaware advises corporations to use the method that results in the lower franchise tax amount. You should calculate the franchise tax using both methods to determine which method works best for your corporation. The vast majority of startups use the Assumed Par Value Capital Method since it typically results in significantly less tax.
You may be asking yourself, why should I authorize a large number of shares if I only have to pay $175 in franchise taxes if my corporation has 5,000 authorized shares? Well, it’s more about optics and planning for the future than anything else. Many early-stage companies, particularly those in the technology industry, authorize 10 million shares (or more), providing them with flexibility to allocate shares among founders and other shareholders. In addition, having a large number of authorized shares allows the corporation to make larger stock option grants to service providers, which leaves the service providers feeling as if they received something of greater value.
The more important thing to note here is that if you are forming a corporation with a large number of authorized shares, you’ll likely use the Assumed Par Value Capital Method when calculating your franchise tax. You’ll want to be sure that you (1) include a par value for your authorized shares (otherwise, you won’t be able to use the Assumed Par Value Capital Method) and (2) use a low par value per share in order to avoid paying excessive fees.
Consult a knowledgeable corporate attorney and an accountant to determine the best configuration of authorized shares and par value for your corporation.
I received a bill from Delaware stating that I owe thousands of dollars in franchise taxes. What should I do?
Don’t panic! The default method for calculating the franchise tax is the Authorized Shares Method. The franchise tax notice you received most likely used this method, resulting in a hefty tax bill if your corporation has a large number of authorized shares. More often than not you can recalculate the amount of franchise tax owing using the Assumed Par Value Capital Method. Doing so often results in significantly lower taxes owing in these situations. Your attorney or accountant should be able to assist with recalculating the franchise tax.
How do I file the annual report and pay the franchise tax?
The filing of the annual report and payment of the franchise tax can be made online using the Delaware Secretary of State’s website (see link below). To make the filing and payment, you’ll need your corporation’s seven-digit Business Entity File Number, which is the number assigned to corporations that are registered in Delaware. If you’ve misplaced this number, you can easily find it using the Secretary of State’s business entity name search online.
In order to complete the annual report, you’ll need to provide the corporation’s physical address; the names and physical addresses of all directors; and the name, title and physical address of at least one of the corporation’s officers.
Here is the link to the website where you can file the annual report and pay the franchise tax for your corporation.