Posted by Pat Raskob

Franchise Tax

Franchise Tax

Franchise tax applies to taxes paid by certain companies that wish to do business in certain states. Also called a privileged tax, it gives the company the right to be established and/or to operate in this state. Businesses in some states may also be subject to tax, even if licensed in another state. Despite its name, a franchise tax is not taxed on franchises and is entirely separate from state and federal income taxes that must be filed each year.


What is a franchise tax?

A franchise tax is a tax levied by the state on certain businesses for the right to exist as a legal person and conduct business in a particular jurisdiction. As of 2020, these states included California, North Carolina, Oklahoma, Tennessee, Alabama, Arkansas, Illinois, Louisiana, Mississippi, New York, Delaware, Georgia, and Texas. Kansas, Missouri, Pennsylvania, and West Virginia have suspended franchise taxes.

Contrary to what the name suggests, a franchise tax is not a tax levied on a franchise. Instead, it's billed to corporations, partnerships, and other entities, such as limited liability companies (LLCs), that operate within set limits. Some entities are exempted from franchise taxes, including sister organizations, non-profit organizations, and some LLCs. Below is a more comprehensive list of exemptions. Businesses operating in more than one state usually pay a franchise tax in the state in which they are officially registered.

Contrary to what the name suggests, a franchise tax is not a tax levied on a franchise.


Franchise tax rate

Franchise taxes do not replace state and federal income taxes, so they are not income taxes. These taxes are paid in addition to income tax. These are generally paid annually, with other taxes due. The amount of franchise tax can vary widely depending on state tax rules. Some states calculate the amount of deductible tax payable based on the assets or equity of an entity, while other states analyze the value of a company's equity. However, other states may apply a flat rate to all businesses operating in their jurisdiction or may calculate the tax rate on the business's gross income or paid-in capital.


Special considerations

A business that operates in more than one state may be required to pay franchise fees in each state where it is officially registered. Sole proprietorships are generally not subject to franchise tax and other corporate income tax forms, partly because such companies are not officially registered in the state where it operates. The following entities are not subject to deductible tax:

  • A non-profit self-insurance fund established per Chapter 2212 of the Insurance Code

  • A qualified trust per section 401(a) of the Internal Revenue Code

  • An exempt trust in accordance with section 501(c)(9) of the Internal Revenue Code

  • Certain grant funds, estates of individuals, and security deposits

  • Certain incorporated passive entities 

  • Exempt entities per the Fiscal Code, chapter 171, subchapter B

  • General partnership when the direct ownership is entirely made up of natural persons (except limited liability companies)

  • Individual ownership (except for single-member LLCs)

  • Management of real estate mortgage investments and certain eligible real estate investment funds (REITs)

  • Political committees not incorporated


Franchise tax vs. income tax

There are important differences between a deductible and an income tax. Unlike traditional state income taxes, franchise taxes are not based on a company's profits. A business entity must register and pay franchise taxes whether or not it makes a profit in a given year. State income tax and the amount paid depending on what the organization earns during the year.

Income tax also applies to all businesses that earn income from public sources, even if they cannot operate within its limits. Some states may define the business differently because several factors are considered in establishing the link, including whether the business sells in the state, has employees in the state, or has an actual physical presence in the state.


Example of the franchise tax

As mentioned above, each state may have a different method of calculating franchise taxes. Take Texas as an example. The state comptroller taxes all entities that are doing business in the state and requires them to file an annual franchise tax return by May 15. The state calculates franchise tax based on the company's margin, which is calculated in one of four ways:

  • Total income less compensation paid to all employees

  • Total income multiplied by 70%

  • Total revenue minus $1 million

  • Total revenue minus COGS (cost of goods sold)

Business income is calculated by deducting legal exclusions from the amount of income reported on a company's federal income tax return.


Bottom Line

Franchise taxes allow businesses to do business in one state, although states apply different tax rates based on their legal process and gross income levels.


Summary

  • A franchise tax is paid by certain companies that want to do business in certain states. Contrary to what the name suggests, a franchise tax is not a tax levied on a franchise.

  • Certain entities are exempt from franchise taxes, including fraternal organizations, non-profit organizations, and certain limited liability companies.

  • Franchise taxes are paid in addition to state and federal income taxes.

  • Kansas, Missouri, Pennsylvania, and West Virginia have suspended deductible corporate taxes.

  • The amount of franchise tax can vary widely depending on state tax regulations and is not calculated based on the organization's income.


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Pat Raskob
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