Corporate Franchise Tax: Everything You Need to Know
A corporate franchise tax is a tax imposed by a state on corporations, LLCs, and partnerships for doing business or incorporating their business in that state.10 min read
A corporate franchise tax is a tax imposed by a state on corporations, LLCs, and partnerships. This tax is assessed to these companies for the privilege of either doing business in the state or incorporating their business in that state. Like income taxes, typically franchise taxes are assessed annually. When a business fails to pay a franchise tax, this may result in the business being disqualified from doing business in a particular state.
Corporate Franchise vs Income Tax
There are two different types of taxes that can be assessed on businesses: corporate income taxes and franchise taxes. The difference is found in looking at what exactly is being taxed. Income taxes apply to profit. Franchise taxes do not apply to profit. Another difference between income tax and franchise tax is the entity that does the taxing.
Companies pay income taxes on the business's profit, or the company's net income. Companies that don't make a profit do not have corporate income tax liability. As a general rule, only corporations are required to pay corporate income taxes. Sole proprietorships, limited liability companies, and partnerships do not pay income taxes. Instead, the profits from those types of companies are passed on to the owners. The owners then pay income taxes. Small business corporations that operate as S corporations also don't pay federal income taxes. However, S corporations may be responsible to pay state taxes.
Corporate franchise taxes, on the other hand, are essentially fees that companies must pay for the privilege of doing business in a particular city or state. Franchise taxes are not based on profit. Even companies that make very little money, break even, or lose money may be required to pay franchise taxes.
Franchise taxes come in many forms:
- A simple flat fee.
- A fee that varies based on the net worth of the company.
- A fee based on the company's gross receipts, or the amount of business that a company performs in the jurisdiction.
There are different types of companies that are subject to franchise taxes in different states. However, it is common for franchise taxes to be assessed not just to corporations but to other companies as well.
In addition to federal corporate income tax, some states assess a corporate income tax. Some cities also assess corporate income taxes. Frequently, states assess a corporate income tax using a single rate for all corporations, regardless of the size of their income. Other states have a series of different tax brackets. Only about half the states impose a franchise tax. The federal government does not impose a franchise tax and has no equivalent to the franchise tax. The way to determine whether a business is subject to the state corporate income tax or the state franchise tax depends on whether a business has a nexus in the state.
As an example, Louisiana requires all corporations, along with entities that are considered corporations for federal income tax purposes, to file a state corporate income tax return if they receive income from Louisiana sources. This applies even if they do not make a profit. If they have an exemption from the IRS, they can submit it to the state taxation department to receive an exemption from state income tax as well.
Corporations in Louisiana pay tax according to a table, depending on the size of their net income. This graduated taxation amount ranges from four percent on the first $25,000 of their net income to eight percent on all income earned over $200,000.
The state of Louisiana's due dates for taxes are representative of most other states that impose corporate income taxes. If the corporation's tax year begins on January 1, it must submit its return along with payment by the 15th day of the fifth month, which is May 15.
Louisiana, along with many other states, requires corporations to pay estimated income taxes at intervals throughout the year if they expect their income tax to be $1,000 or more for the tax year. Installments are due quarterly on the 15th of the month. Estimated tax may be recalculated if needed, and the new estimated tax payments may increase or decrease. The difference will then be divided between each remaining installment. Overpayments can either be credited or refunded.
As a general rule, businesses pay corporate franchise tax if they have a nexus in the state seeking to assess the corporate franchise tax. When a business doesn't have a company that does business in a given state, there is no nexus to that state, and there's no liability and no tax consequences.
Federal law requires a physical presence within a state, either a business address or business location within the state, for corporate tax. However, for franchise tax purposes, a physical presence is not required. Generally, the rule is that if you are required to collect sales tax based on sales to customers in a particular state, there is probably sufficient nexus in that state to be required to pay franchise tax. States, however, have different rules. Frequently, companies with a presence in many different states hire professionals to assist them in sorting out tax nexus issues.
Why Franchise Taxes May Not Be Good for Businesses
Franchise taxes are frequently referred to as "privilege taxes." This means that they are the taxes imposed on entities for "the privilege" of being able to do a business, provide a service, or sell products within a state. There are some states, such as Louisiana, that impose both income taxes and franchise taxes on companies doing business in the state. This results in the tax rate for the state being higher, and it can also result in driving businesses out of the state.
Other states are choosing to eliminate franchise taxes. States like West Virginia have found that eliminating the franchise tax encourages business growth.
What States Have Franchise Taxes?
Currently, there are 14 states that have franchise taxes, including the following:
- New York
- North Carolina
How Do States Determine Franchise Taxes?
Each individual state has its own individual criteria for determining the type of entities that are required to pay franchise tax and how they are going to tax such entities.
States base franchise taxes on different criteria, which can include the following:
- Income, in which case the franchise tax acts functionally the same as an income tax
- The number of shares of stock, the value of capital stock, or the par value of stock
As an example, Louisiana requires corporations to pay a franchise tax if the following are true:
- The corporation is taxed as a corporation for the purpose of federal income tax.
- The corporation is formed in Louisiana and follows Louisiana business laws.
- The corporation is currently doing business in Louisiana, or is qualified to do so.
- The corporation is continuing its charter with the state, allowing it to continue doing business.
- The corporation owns capital, property, or a physical plant within Louisiana, either directly or indirectly, through some type of business organization.
You will need to consult the specific laws for your state, but Louisiana assesses corporation franchise tax with a graduated flat rate. It charges $1.50 for each $1,000 of the company's capital within Louisiana up to $300,000, and $3 for each $1,000 over $300,000. It charges a minimum franchise tax of $110.
Louisiana's franchise tax returns are due by the 15th day of the fifth month following the first day of a corporation's tax year. When a corporation files its first return, it is due by the 15th day of the third month following the date the corporation is officially formed.
How Taxes Apply to C Corporations
Corporations (and some partnerships) taxed under subchapter C of the internal Revenue Code, commonly referred to as “C corps,” are subject to the corporate franchise tax.
In regards to income taxes, C corps work differently than S corps. C corps pay tax as individual income tax for the profits distributed by the corporation as dividends. They also pay tax as a corporate entity for profits that are earned.
Entities Exempt From the Corporate Franchise Tax
There are a number of entities that are exempt from corporate franchise tax. These include so-called “pass-through entities.” Pass-through entities include most partnerships, limited liability corporations, and S corps. These types of businesses pay taxes through the individuals' tax returns, rather than on the business entity's income. These entities are subject to minimum fees, as discussed further below.
Insurance companies are also exempt from corporate franchise taxes. Instead, insurers pay something referred to as a “premium tax.”
Credit unions are also not taxed under corporate franchise taxes. Federal law protects federally chartered credit unions from this type of taxation. State laws also extend an exemption to state-chartered credit unions, exempting them from corporate franchise taxes.
Similarly, charitable organizations and other business entities that are exempt from federal income taxes are not subject to federal corporate franchise taxes.
Tax Base as Profits
A company's tax base is considered taxable income. Put another way, the profits of C corporations, which are taxable income, make up their tax base. State law defines the tax base by specifying what counts as taxable income using the definition provided for federal corporate income tax.
By way of example, consider federal depreciation rules. Generally, federal depreciation rules are followed in states such as Minnesota, with the exception that bonus depreciation and expensing are subject to special rules in the state of Minnesota. Minnesota deviates from the federal rules in a few other ways. For example, it taxes some income the federal law considers exempt from taxes. This includes state bond interest and local bond interest. It also does not allow for percentage depletion in its tax structure. Minnesota applies a flat tax rate of 9.8 percent to Minnesota-based taxable income.
In states like Minnesota, income is apportioned based on the percentage of sales a business makes to Minnesota buyers. Many corporations, particularly in the internet age, make numerous sales across state lines. Under the United States Constitution, states are only allowed to tax for the income of a business that is "fairly apportioned" to the activity the business performed within that state.
All states use a formula apportionment considering the in-state percentage of one or more factors. Minnesota, for example, takes a multistate corporations' income and considers the proportion of sales made to buyers within the state of Minnesota. When there is a unitary business that operates through several corporations, such as a parent-subsidiary combination, all the income for the business is combined. This method is referred to as the combined reporting method.
Various Tax Credits Apply
Corporate franchise taxes can be reduced by tax credits. There are several different tax credits that are available to businesses. In Minnesota, tax credits are available for the following types of things:
- Research and development
- Jobs credit under the JOBZ program
- Historic structure rehabilitation credit
- Taxes paid to different states
Revenues Go to the General Fund
Revenues gained from corporate franchise tax collections go to the general fund. For example, the Minnesota Management and Budget office estimated that in February 2015, corporate franchise tax collections totaled approximately $1.32 billion for fiscal year 2015. The Minnesota Management and Budget office also estimated that 2016's corporate franchise tax collection would amount to approximately $1.3 billion.
Revenues for Franchise Taxes Are Volatile
With corporate franchise tax collection, these tax revenues are the most volatile. When the economy goes into a recession, corporate profits drop, and franchise tax revenues also drop.
For example, in 2007, which was considered an expansion year, revenues were 1.17 billion in the state of Minnesota. By 2010, during the recession, revenues had dropped to 663 million in the state of Minnesota. This is a reduction of 43 percent in just three years. Five years later, in 2012, revenues had recovered to 1.04 billion. This led to an increase in corporate franchise tax for the state of Minnesota of 57 percent. Such volatility makes it difficult for states to rely on corporate franchise tax as a steady source of revenue.
A Minimum Tax Applies in Franchise Tax Law
An alternative minimum tax, also referred to as an AMT, applies under the franchise tax codes in some states. This state AMT closely follows a similarly situated federal AMT.
It works like this: corporations compute the taxes owed under the alternative minimum tax using a broad tax base — in other words, less generous depreciation rules — and compare this rate against a similar calculation under a lower tax rate. If the alternative minimum tax, or AMT, results in a higher amount of tax to be paid, the corporation is obligated to pay the higher amount to the state as their share due.
A Minimum Fee Applies to Most Entities
All corporations, including S corporations and C corporations as well as partnerships and LLCs, must pay, in some states, a minimum fee in addition to the minimum tax. This minimum fee is based on their property owned within the state, their sales, and their payroll. This fee is considered an add-on fee. In other words, it is “added on” to the taxes due and owing.
This fee is paid in addition to the tax the corporation has computed under either their regular income tax or alternate minimum tax. In Minnesota, in 2013, the Minnesota Legislature increased these fee amounts. Additionally, the Minnesota Legislature provided for a rule that allows the state to adjust for inflation each year going into the future.
Getting Set Up to Pay Franchise Tax
Since sole proprietorships do not need to register with the state where they form and do business, they do not need to pay franchise tax or set up an account to do so. However, other business entities — including corporations, partnerships, and LLCs — need to file an application specific to that type of business structure. After your business is registered with the state, the state will contact you with further information.
Can You Get an Extension for Paying Franchise Tax?
All states that require businesses to pay franchise tax have different rules. However, most are similar to Louisiana's rules, which allow extensions up to seven months from the return's due date. If your business needs to request an extension, it must be submitted before the return's original due date. If it is submitted after that date, it will not be approved.
The Louisiana Department of Revenue allows businesses to request an extension electronically through the portal on its website. Requests can also be filed electronically through an automated telephone system; taxpayers need to have their account numbers when they call. A third way to request an extension is by using tax preparation software that offers that capability. In that case, you can usually make a payment through the tax preparation software as well.
Louisiana, as well as many other states, offers methods for making franchise tax payments online. Businesses that plan to mail in checks or money orders can print out an extension payment voucher, which may be found on the state's website. Be sure to check your own state's Department of Revenue or equivalent agency for detailed instructions on requesting extensions and making payments.
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