Franchise taxes: What founders of VC-backed startups need to know
Franchise taxes are levied on startups that are incorporated or operate within a specific state. Startups that are incorporated in or do business across multiple states may owe franchise taxes in several jurisdictions, and it doesn’t matter if your startup isn’t profitable – you still could owe franchise taxes.
It’s also not something that founders should ignore. Failing to pay franchise taxes in every state where your startup operates can generate financial penalties, affect your startup’s credit rating, and create legal consequences like having your business license suspended or revoked. Good law firms, hired by VCs during due diligence, will catch these errors - and since they can take time to clear up, it can delay your fundraise close! It’s better to keep up to date with these taxes, since, if you are working with a good CPA, you don’t actually end up with much of a tax bill to stay current.
Franchise taxes are often a flat fee or calculated based on various factors such as a company’s net worth, capital stock, or the number of shares issued. The calculation methods and rates vary by state, with some states like California imposing a standard flat fee, while others, like Delaware, use a more complex formula that can significantly impact larger startups with higher asset values or more shares.
In this article, we’ll explore key considerations around franchise taxes, outline the filing requirements for some of the most common states where startups operate, and offer guidance on how to stay compliant.
What is a franchise tax?
A franchise tax is a state-imposed tax levied on businesses for the privilege of conducting business within the state. Unlike income taxes, which are calculated based on a company’s earnings, franchise taxes aren’t based on revenue, profits, or the physical presence of the business. Instead, they are essentially fees for the legal right to operate within a particular state, regardless of whether or not the business turns a profit.
Franchise taxes are often misunderstood because they aren’t tied to traditional measures of profitability or sales. Even if your startup has no revenue or is operating at a loss, you may still be required to pay a franchise tax. This is particularly important for startups, especially those structured as C-Corporations (C-Corps) in Delaware, a common choice for venture-backed companies due to its favorable corporate laws.
Why franchise taxes matter for Delaware C-Corps:
In Delaware, C-Corps are a popular entity structure for startups, especially those seeking venture capital. While Delaware is known for being business-friendly, it still requires companies to pay a franchise tax for the right to incorporate in the state. This tax applies whether or not the business operates in Delaware and is separate from any income taxes the business may owe.
Delaware C-Corps are also required to comply with franchise tax laws in other states if they operate, hire employees, or generate revenue outside of Delaware, such as in California, where franchise tax obligations exist for companies doing business within the state.
What is the annual franchise tax report?
The Annual Franchise Tax Report is a mandatory filing for corporations, LLCs, and other registered businesses in many states. It maintains a company’s compliance with state laws and preserves its corporate status. The main purposes of the report include:
- Compliance with state laws. Filing the report ensures that a business complies with state laws and remains in good standing.
- Preserving corporate status. Timely filing helps maintain corporate status, protecting company officers from increased liability.
- Revenue for the state. Franchise taxes contribute significantly to state revenues, particularly in states like Delaware and California.
The report is used to calculate the company’s franchise tax liability, which varies based on factors like authorized shares, assets, or gross receipts. Additionally, the report verifies essential company details, such as the number of authorized shares and corporate structure. Accurately reporting and paying taxes allows businesses to avoid penalties and maintain good standing with the state.
Failure to submit the report accurately and on time can lead to penalties and interest charges. For example, in Delaware the penalty for late filing is $200, plus 1.5% interest per month on the unpaid tax and penalty. Non-compliance can also result in the loss of good standing, creating additional hurdles for the business to regain compliance.
It’s important to note that the requirements of the franchise tax report vary by state. Kruze Consulting has clients in many different states, so we understand the state-specific requirements. For example:
- Delaware. Delaware franchise tax calculations can be complex, with businesses having the option to calculate their tax liability using either the authorized shares method or the assumed par value capital method. If your Delaware franchise tax seems high or incorrect, please review these common errors. And please note the two major reasons Delaware franchise tax filings get rejected.
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California. California imposes a minimum franchise tax on LLCs and corporations, even if they are operating at a loss.
[Video: https://youtu.be/rimNGQfqbc8?si=hCi_wwyNuGGnBb93 ] - New York. New York calculates franchise taxes based on gross receipts or net income, depending on the company type.
- Texas. Texas imposes a margin tax, calculated based on a business’s total revenue, minus deductions.
Filing requirements and deadlines
The deadlines for filing franchise tax reports and paying the associated taxes differ depending on the state. Below are the general filing deadlines and minimum tax requirements for some key states:
- Delaware. Delaware corporations are required to file their annual report by March 1st each year. A minimum tax of $175 applies to most corporations.
- California. Corporations must file their report and pay a minimum franchise tax of $800 by the 15th day of the 4th month after the close of their fiscal year. Learn more on our California Franchise Tax page.
- New York. The report is due by the 15th day of the 3rd month after the fiscal year ends. The franchise tax depends on gross receipts or net income.
- Texas. The franchise tax report is due on May 15th each year. Businesses with revenue below a certain threshold may owe no tax but must still file the report.
Avoiding penalties and maintaining compliance
To avoid penalties and interest charges, you need to make sure to file the annual franchise tax report accurately and on time. States may impose significant fines and interest on late payments, which can impact the company’s financial health and its ability to operate. Businesses that lose their good standing due to non-compliance may face higher fees and complicated revival processes. And remember, even startups that lose money will still owe franchise taxes.
Paying franchise taxes
When paying franchise taxes, startups often face the challenge of navigating the varying rules and requirements across different states. Kruze Consulting can guide startups through the process of calculating and paying their franchise tax, so your payments are accurate and you stay in compliance.
The first step is understanding how franchise tax liability is calculated. This calculation can depend on several factors, including the company’s revenue, authorized shares, assets, or gross receipts, which vary depending on the state’s tax laws. For example, in Delaware, the tax can be calculated based on either the authorized shares method or the assumed par value capital method, while in California, businesses must pay a minimum franchise tax, regardless of profitability.
Once your tax liability is determined, your startup will need to submit your payments through online portals or filing systems provided by each state where you owe taxes. Here’s a quick overview of common state-specific procedures:
- Delaware. Startups can pay their franchise tax online via the Delaware Division of Corporations’ e-filing system. Kruze Consulting can provide comprehensive support, helping businesses accurately calculate their tax liability and complete the necessary filings by the March 1st deadline.
- California. Payments can be made through the California Franchise Tax Board’s online portal. Kruze Consulting can assist with tax filings and payments by first making sure that you meet the state’s minimum franchise tax requirements and that your payment is processed correctly.
- Texas. Texas startups can make payments through the Texas Comptroller’s Webfile system. Kruze can help clients meet the May 15th filing deadline and understand how the margin tax is calculated based on their business’s revenue.
- New York. Franchise taxes can be paid via the New York State Department of Taxation and Finance’s Online Services. Kruze Consulting can help you calculate your tax obligation, based on your business’s gross receipts or net income.
In addition to guiding you through these state-specific processes, Kruze Consulting can also help manage your estimated tax payments. In states like Delaware, where taxes exceeding $5,000 must be paid in quarterly installments, Kruze will make sure these payments are made on time to avoid any penalties. For Delaware C-Corporations, the payment schedule breaks down as follows:
- June 1. Pay 40% of the estimated annual amount.
- September 1. Pay 20% of the estimated annual amount.
- December 1. Pay 20% of the estimated annual amount.
- March 1 of the following year. Pay the remaining balance.
This installment payment structure helps spread the tax burden throughout the year rather than requiring a lump sum payment at the end of the year.
Consequences of late payment or non-payment
Failing to pay franchise taxes on time can lead to significant consequences for startups. The penalties for late payments vary by state but can include:
- Late fees. States may impose fines for missing payment deadlines. For example, Delaware charges a $200 late fee plus 1.5% interest per month on the unpaid tax and penalty.
- Interest charges. In addition to late fees, states typically charge interest on overdue taxes, which can accumulate quickly if the issue isn’t resolved.
- Loss of good standing. Startups that fail to meet their franchise tax obligations may lose their good standing status, which can have serious implications. This could hinder your ability to secure funding, enter into contracts, or expand your business. If a company falls out of compliance, it may have to file for reinstatement or obtain a certificate of revival, which can be costly and time-consuming.
- Legal risks. In extreme cases, continued non-payment could lead to further legal action from the state, including the potential dissolution of the business entity.
Franchise tax rates by state
Franchise tax rates vary significantly by state, with some states applying a flat fee and others calculating the tax based on factors such as capital, assets, or income. Below are examples of franchise tax rates in states common for Kruze clients:
- Delaware. Delaware franchise taxes can range widely depending on the company’s structure and number of authorized shares, with a minimum tax of $400 for corporations. Learn more here.
- California. California imposes a minimum franchise tax of $800 annually, regardless of income. For C-Corporations, additional taxes may apply based on income. Learn more here.
- New York. New York imposes a franchise tax based on a company’s income, with varying rates depending on income level, with a minimum tax of $25.
- Texas. Texas levies a franchise tax based on revenue, with a 0.375% rate for retail and wholesale businesses and 0.75% for most other entities.
- Florida. Florida does not impose a franchise tax; however, corporations must pay a corporate income tax based on their net income.
Talk to the startup tax experts
Navigating franchise tax obligations can be complex, especially for startups. Kruze Consulting is here to simplify the process, and provides comprehensive services, from calculating your franchise tax to making sure you select the most cost-effective method for your business, such as the assumed par value method over the authorized share method in Delaware. Our Delaware Franchise Tax Calculator makes compliance easier and helps prevent overpayment.
In addition to managing tax deadlines and ensuring accurate filings, Kruze Consulting offers personalized, strategic advice tailored to your startup’s needs. Beyond franchise taxes, we also assist with income, payroll, and other tax obligations, providing a full suite of services to keep your company compliant and focused on growth.
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