Franchise taxes, despite their name, are not taxes that only franchises such as Papa Johns’s and Burger King must pay. Rather, they apply to most businesses in franchise tax states. If a business is required to register with the state, it most likely must pay such a tax.
If a state has a high corporate income tax, it typically has a low or no franchise tax (and vice versa). Quite a few states have phased out their franchise taxes because of the “double taxation” burden that can discourage a business from operating in the state.
Many franchise tax states are in the southeast United States. The taxes are annual and state-specific. Great variability exists as far as the tax rates, deadlines, collection entities, and other factors.
What is a Franchise Tax?
It is a tax that nearly all businesses must pay to the state they do business in. Not all states impose this tax, though.
Franchise taxes cover virtually every business, not just franchises. This tax can vary quite a bit from state to state, so it is essential to research the specifics in your state.
Franchise taxes are mandatory and do not depend on whether a business is profitable.
They are sometimes called a privilege tax because states levy them on businesses for the privilege of doing business in the state.
Self-proprietorships are a common type of business that is exempt.
A business that simply owns property within the state may have to pay some franchise tax even if that is the extent of its physical presence. A business can still have to pay franchise taxes if it is chartered in another state.
Companies doing business in different states may have to pay such taxes in all these states.
The tax rate can be a flat rate, some percentage, or something else.
If you own or operate a business that is expected to settle franchise tax, the state will let you know you are required to pay. It will probably notify you in many different ways.
So, do not stress too much about your business being caught unaware by a surprise franchise tax amount. Odds are extremely high that you will know about it in advance and be able to plan to pay for it.
Which states have franchise tax?
The states include:
Delaware,
California,
Alabama,
Arkansas,
Illinois,
Georgia,
Louisiana,
Missouri,
Mississippi,
North Carolina,
Oklahoma,
New York,
Texas,
Tennessee,
Pennsylvania,
and West Virginia.
Other states may have it in some form.
Who has to Pay a Franchise Tax?
Virtually, all businesses pay some sort of franchise tax if their state has them. More specifically, a business that must register with the state is typically expected to pay this tax. Some states do not require all business types to register.
For example, sole proprietorships do not always have to register. In these states they conduct business in, they may not have to pay any of this tax. However, practically all limited liability companies and corporations partnerships with some type of physical presence in the state are required to pay the franchise tax.
Most general partnerships, some unincorporated passive entities, unincorporated political committees, and some grantor trusts and escrows are others that do NOT have to pay the franchise tax. These taxes are state-specific, not federal.
Pay Franchise Taxes on an E-2 Visa?
If you are an E-2 visa holder in the United States, your company would need to pay any franchise tax it is obligated to under state law. E-2 visa status does not change or add to these tax-imposed requirements.
The Puerto Rico “Tax Holiday”
The good news is that setting up a certain type of business in Puerto Rico can earn your company a near-complete tax holiday. In a typical corporate taxation scenario, a business and its E-2 and EB-5 visa holders pay federal and state corporate income tax and capital gains tax on international income.
Puerto Rico is a territory of the United States. Since Puerto Rico is not a state, U.S. federal tax law does not apply. As such, Puerto Rico’s Act 20 lets certain Puerto Rican companies employing at least one full-time person pay a mere 4 percent in tax for 20 years. It applies to work and income sourced in Puerto Rico. (Previously, the business was required to employ at least five full-time workers, but this provision went away in 2017.)
In contrast, the business tax rates in other states can range from 10 percent to nearly 40 percent.
Many Exceptions Apply
Not every large or small business qualifies, though. The business must provide service from Puerto Rico to the people and companies of the island.
Call centers, importation of goods, online marketing, sales and support, graphics design, loan servicing, financial advising, and software development are examples.
Mobile and portable businesses fit the bill well. Restaurants, franchises, and companies that focus on selling goods to people in Puerto Rico themselves likely do not qualify for this virtual tax holiday.
The Puerto Rican government aims for Act 20 to offer jobs and training for Puerto Ricans.
Some owners of Act 20 businesses in Puerto Rico live elsewhere in the United States and operate the business somewhat remotely. They get paid a salary from the business and pay U.S. income tax.
However, to qualify for Act 20, business owners must spend 183 days per year on the island and be a resident of the territory.
What if you do not pay the franchise tax you are supposed to?
If you don’t pay such a tax as you’re supposed to, there are a few potential consequences.
First, you may be subject to interest and penalties.
Second, the state could revoke your franchise tax certificate, which means you wouldn’t be able to operate your business.
And third, the state could file a civil suit against you to collect the taxes you owe.
So, it’s definitely in your best interest to make sure you stay up to date on your franchise tax payments. Otherwise, you could end up facing some serious repercussions.
Do you have to file a franchise tax return?
If your business is required to pay a franchise tax, you will need to file franchise tax returns with your state’s taxing authority.
The good news is that, in most cases, you can deduct the franchise tax from your federal income taxes. So, if you are thinking about starting a business in a new state, be sure to find out if there is a franchise tax and how it will impact your bottom line.
Who collects franchise tax?
The states administer and collect franchise tax imposed, but different state departments do so depending on the state in question. California has its Franchise Tax Board do the collecting, while in Texas, the Comptroller’s Office takes care of collecting the tax.
Let’s take a quick look at franchise tax rates in three states to give you a better idea of how they work.
California
Franchise taxes apply to LLCs, limited partnerships, limited liability partnerships, and S corporations but do not apply to LLCs and corporations that choose to be treated as corporations.
S corps in California pay such tax with a rate of $1.5% of the corporation’s net income or $800, whichever is greater. LLCs, pay $800 unless they elect to be treated as a corporation. In these cases, they pay the state corporate income tax, not the franchise tax. An $800 franchise tax minimum applies for LLCs and LPs.
Delaware
LPs, LLCs, and general partnerships pay an annual flat rate of $300 tax. Corporations pay from $175 to $250,000 per year in franchise tax, depending on corporation size and how they file.
An online business tax filing option is available.
Texas
Entities within the state must file a franchise tax report annually by May 15, mandated by the Texas comptroller. The tax is based on the company’s margin, which Texas calculates in one of four potential ways:
Total revenue less $1 million;
total revenue minus employee and personnel compensation;
total revenue less cost of goods sold,
and total revenue times 70 percent.
Bottom Line
If you operate a decent-sized business or even a small business in a state that imposes a franchise tax, you may have to pay it. You should get plenty of notice that you owe it, though, and many states do not levy this type of tax.
Careful planning can help you approach your franchise and corporate income taxes strategically. As always, remember that franchise tax is for most businesses, not just franchises.