Franchise Tax: What Business Owners Need to Know

It’s not what you think — your neighborhood McDonald’s franchise isn’t the only type of business that’s subject to franchise tax. Instead, franchise taxes are assessed on business owners of all types in order to conduct business in certain states.

Franchise taxes differ significantly from federal and state income taxes and understanding if or when you are subject to them can help you plan your cash flow and future tax obligations.

What is Franchise Tax

A franchise tax is a government tax that applies to businesses that operate under a specific jurisdiction. Many states impose an annual franchise tax or minimum franchise tax in addition to the federal filings and taxes due each year. 

This extra tax may be assessed on S Corps, LLCs and other business entities.The assessment and calculation of franchise tax depends on where the business is formed and each state has varying rules and methods for calculating what’s due. 

Before you panic and add this to your to-do list, not all states impose a franchise tax, so it’s important to understand your states’ requirements.

Who is required to file and pay a franchise tax?

Each state determines which business entities are subject to franchise taxes and the amount of franchise tax to be paid, but if you own or operate any of the following types of businesses, you may be required to pay franchise taxes:

• Corporations: Regardless of size or profit, franchise tax is typically imposed on both C corporations and S corporations
• Limited Liability Companies (LLCs) and Partnerships: Certain jurisdictions will impose franchise taxes on LLCs and partnerships, however some states will assess alternative taxes, such as annual franchise tax report fees, minimum taxes or a flat fee based on the number of members or partners

How to determine your franchise tax obligations and requirements

The business entity type and where it’s formed are important in determining if a franchise tax is due, but it’s also important to recognize businesses operating in other states. 

If you conduct business in states beyond your resident state, you may have franchise tax nexus — a fancy way of saying you have an additional filing requirement — in additional states.

We won’t get into the details of determining nexus in this post, but if you do business in multiple states, keep in mind that you may owe franchise tax and returns in more than one state.

How is franchise tax calculated?

Franchise tax is calculated in a variety of ways and determined by a state franchise tax board, and the franchise tax rates vary by state. Here are some of the common methods used to calculate franchise tax:

Net Worth Method:

• Many states calculate franchise tax based on the net worth of the business.
• A business’s net worth is usually determined by subtracting liabilities from assets.
• States may have specific rules and adjustments for calculating net worth, so it’s important to refer to the state’s guidelines.

Authorized Shares/Issued Shares Method:

• Some states base the franchise tax on the number of authorized shares or issued shares of the business.
• The tax may be calculated by multiplying the number of authorized or issued shares by a predetermined tax rate.
• The franchise tax rate can vary depending on the state and the classification of the business.

Sales or Gross Receipts Method:

• A few states use the sales or gross receipts of the business within the state as a basis for calculating franchise tax.
• The tax rate may be applied to the total sales or gross receipts generated by the business within the state.

Flat Fee Method:

• In certain states, franchise tax is a fixed or flat fee imposed on all businesses, regardless of their size, net worth, or other factors.
• This method simplifies the calculation process by providing a set amount that businesses need to pay annually

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How to file and pay franchise taxes

Each state will have its own processes and procedures for filing  franchise tax returns and submitting payments, however most states will have the option to submit franchise returns and payments electronically.

It’s worth noting that some jurisdictions are old-school — so keep an eye out for instructions that require you to submit paper returns or vouchers with your tax payments.

Income tax vs franchise tax: What’s the difference?

Income tax is the one you’re probably most intimately acquainted with. Every April, your tax bill or refund is a result of filing your personal income tax return. Income tax is assessed based on your earnings within the tax year.

As an individual, your income tax is assessed on the entirety of your household income, including wages, business profit or investments. As a business owner, income tax is assessed on your business’s profits.

Contrary to income tax, franchise taxes are assessed simply for the right to conduct business in a certain state. Just think of it like paying club dues to help fund initiatives and programs provided by the state.

Franchise Tax FAQs

What if I don’t file and pay franchise tax?

If you miss a franchise tax filing and payment, file and pay as soon as you identify the error. Late filing penalties and interest may be due in addition to penalties and interest assessed on the outstanding franchise tax balance due.

Failing to file and pay franchise taxes can lead to more serious consequences, including legal action by the state. Your business entity could be suspended or forfeited and may impact your ability to conduct normal business operations. In extreme instances, persistent non-compliance could result in lawsuits, asset seizures or garnishments.

Is the Franchise Tax Board the Same as the IRS?

Federal Tax Government = IRS

State Tax Governments = Franchise Tax Boards

Which states have franchise tax returns?

States required to pay some form of tax franchises: Alabama, Arkansas, California, Delaware, Georgia, Illinois, Louisiana, Mississippi, Missouri, Minnesota, Nevada, New Hampshire, New York, North Carolina, Oklahoma, Tennessee, Texas, Vermont, and D.C. 

Please note that this list is not exhaustive, and franchise tax requirements can vary within each state.

Key Takeaways:

• Franchise taxes are assessed on business owners to conduct business in certain states.
• Franchise taxes differ from federal and state income taxes and understanding them helps with cash flow and future tax planning.
• Franchise tax applies to various business entities such as corporations, LLCs, and partnerships.
• Franchise tax can be calculated based on net worth, authorized or issued shares, sales or gross receipts, or a flat fee.
• Income tax is assessed on personal or business earnings, while franchise tax is for the privilege of conducting business in a state.
• Non-compliance with franchise tax obligations can result in penalties, interest charges, legal action, and business suspension or forfeiture.
• Franchise tax boards handle state tax matters, while the IRS handles federal taxes.