DEFINITION of Franchise Tax
Franchise tax is a tax levied at the state level against businesses and partnerships chartered within that state. In some states, companies with operations in that state may also be liable for the tax even if they are chartered in another state. This is a privilege tax that gives the business the right to be chartered and/or to operate within that state.
Note that a franchise tax is not a tax on franchises.
BREAKING DOWN Franchise Tax
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 2017, states that incorporate a franchise tax are Alabama, Arkansas, Delaware, Georgia, Illinois, Louisiana, Mississippi, Missouri, New York, North Carolina, Oklahoma, Pennsylvania, Tennessee, Texas, and West Virginia.
Calculating the Franchise Tax
The amount of franchise tax in any given state can differ greatly depending on the tax rules within each state. Some states will calculate the amount of franchise tax owed based on assets or net worth of the business, while other states look at the value of capital stock of the company. Still other states might charge a flat fee to all businesses operating in its jurisdiction or calculate the tax rate on the company’s gross receipts or paid-in capital. For example, in the state of California, the amount of franchise tax a firm is subject to is either the California net income times the appropriate tax rate or an $800 minimum franchise tax, whichever is greater. The state of Texas 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, or; total revenue minus $1 million.
Franchise Tax vs. Income Tax
Franchise taxes are not based on a corporation’s profit, therefore, whether a business entity makes a profit or not in any given year, it must pay the franchise tax. This is how the franchise tax differs from the state corporate income tax which is imposed on businesses that make profit. The income tax is also applied to all corporations that derive income from sources within the state, even though they do not do business in it. “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.
Businesses Exempt from Franchise Tax
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:
- 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 and certain qualified real estate investment trusts
- a non-profit 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