California Franchise Tax

Who pays the California Franchise Tax?

The California Franchise Tax applies to various business entity types, including:

• C corporations
• S corporations
• Limited Liability Companies (LLCs)
• Limited Partnerships (LPs)
• Limited Liability Partnerships (LLPs)

California Franchise Tax rates and minimum payment

The California Franchise Tax rates depend on your business’s tax classification:

• C corporations: 8.84% of net income or $800, whichever is greater
• S corporations: 1.5% of net income or $800, whichever is greater
• LLCs, LPs, and LLPs: $800 minimum

Consequences of franchise tax non-payment for VC-backed startups

Failing to pay your California Franchise Tax can have severe repercussions for your startup, especially if you’re VC-backed or planning to raise funds. Here’s what could happen:

Impact on fundraising

1. Loss of good standing: When your franchise tax lapses, your company loses its “good standing” status with the California Secretary of State. This status is crucial for fundraising, as investors and their legal counsel usually check this during due diligence. At least the good ones do, and it’s unlikely that anyone doing a Series A or B won’t check this.
2. Derailed funding rounds: A lapsed franchise tax can delay or even derail ongoing funding rounds. VCs may view this as a red flag, indicating poor financial management or lack of attention to crucial compliance matters. We can’t tell you how many times a prospective client has come to us in a frenzy because they got a term sheet, and the VC then came and let them know that their status has lapsed. This will slow down your fundraise (see the insurance problems and director liability bullets below).
3. Increased investor scrutiny: Even if you resolve the issue quickly, it may lead to increased scrutiny from potential investors, potentially complicating your fundraising efforts. Because it makes you look junior varsity, the VC is likely to put more time and effort into making sure your other compliance and legal paperwork has been done correctly.

Operational challenges

1. Payroll issues: Your company may lose its ability to process payroll legally. This could result in missed or delayed payments to employees, potentially leading to staff turnover and legal issues. This is a serious issue.
2. Banking problems: Banks may freeze your company’s accounts or refuse to process transactions if your business is not in good standing with the state, or at a minimum it will be close to impossible to open new accounts.
3. Insurance complications: Your business insurance policies may become invalid, leaving your company exposed to various risks without coverage. Note that your insurance company may or may not notify you about this. And keep in mind that VCs always want their portfolio companies to have D&O insurance; it’s usually baked into the investment legal paperwork.
4. Contract voidability: Contracts entered into while your company is suspended may be voidable at the discretion of the other parties, putting your business relationships at risk.

Legal and financial ramifications

1. Penalties and interest: The California Franchise Tax Board will impose penalties and interest on the unpaid tax, increasing your financial burden.
2. Personal liability: Directors and officers may become personally liable for some of the company’s debts incurred during the period of suspension. VCs hate personal liability, so don’t let this happen.
3. Loss of legal rights: Your company may lose the right to use its name in California, and it cannot bring a lawsuit or defend itself in court while suspended.
4. Compliance cascade: Failure to pay franchise tax often leads to other compliance issues, such as inability to file annual reports or maintain required business licenses.

Recovery process

Recovering from a franchise tax lapse can be time-consuming and costly:

1. Revivor process: You’ll need to go through a “revivor” process to reinstate your company, which involves paying all back taxes, penalties, and interest.
2. Professional fees: You may need to hire legal and accounting professionals to help navigate the reinstatement process and address any resulting complications. While we, as CPAs who know California rules really well, get paid to do this… it’s not really the kind of work we want to do - so don’t let it happen to you.
3. Reputation damage: You are just going to look like you don’t know what you are doing to your VCs. You don’t want them questioning your chops.

For VC-backed startups, maintaining compliance with franchise tax obligations is crucial. The potential disruption to your fundraising efforts and operations far outweighs the cost of the tax itself. Always prioritize your franchise tax payments and consider setting up automatic reminders or working with a startup-focused accountant to ensure you never miss this critical obligation.

Articles of Organization and California Franchise Tax

When forming your business in California, you’ll need to file Articles of Organization (for LLCs) or Articles of Incorporation (for corporations). These documents are essential for various business activities, including:

• Opening a bank account
• Undergoing VC due diligence
• Establishing your company’s legal existence in the state

It’s important to note that the filing of these documents often triggers your obligation to pay the California Franchise Tax. Here are some key points to remember:

1. The terminology can vary by state. In California, you’ll typically hear “Articles of Organization” for LLCs and “Articles of Incorporation” for corporations.
2. The date on your Articles of Organization or Incorporation is crucial for determining when your California Franchise Tax obligation begins.
3. For corporations, remember that you’re exempt from the minimum franchise tax for your first year. However, this exemption doesn’t apply to LLCs.
4. When filing your Articles, consider including a “future file date” if you’re forming your business late in the year. This can help you avoid paying the franchise tax for a short initial tax year. Remember to always work with a lawyer who knows startups!
5. Keep your Articles of Organization or Incorporation safe, as you may need them for future tax filings or business transactions. Here is how to find your articles of incorporation on various state’s websites.