Many U.S. states have taxes on business income, in various forms. Some states tax only corporations, while others tax most business types. States call these taxes different things, and meanings get confused.
One of these taxes is a franchise tax. Learn what it is, which states have it, and how it affects your business.
What is a Franchise Tax?
A franchise tax is charged by a state to businesses for the privilege of incorporating or doing business in that state. Franchise taxes, like income taxes, are usually imposed annually.
Failure to pay franchise taxes can result in a business becoming disqualified from doing business in a state.
A franchise tax is not a tax on franchises. That is, it's not a way to tax all the McDonald's franchises in a state.
Franchise Taxes are a State Tax
The U.S. government doesn't impose franchise taxes on businesses; they are a state tax.
Franchise taxes can be different in each state. In California, for example, franchise taxes, under the state Franchise Tax Board, are basically income taxes, paid by individuals and businesses each year.
Any business that is required to register with a state, including corporations, partnerships, and LLCs, may be charged a franchise tax.
Sole proprietorships are not usually subject to franchise taxes and other forms of state business income tax, because these businesses are not formally registered with the state in which they do business.
Franchises Based on Nexus
Franchise taxes are imposed on companies that do business in a state; this is the concept of nexus. Determining nexus is complicated and can be based on factors including whether or not the business:
- Sells goods or services in the state
- Has employees in the state
- Has a physical location in the state
Tax nexus is also different for sales taxes as opposed to income taxes and franchise taxes.
Sales tax nexus defines the level of connection between a sales tax jurisdiction and a business. Franchise or income tax nexus is defined by business type combined with whether the entity is doing business in that state, which is defined differently for each state.
A business may do business in several states (depending on how the state views the business). Usually, the business is formally registered in one or multiple states. If your business is formally registered in several states or does business in multiple states, you will probably have to pay franchise taxes in each of them.
Franchise Taxes vs. Business Income Taxes
Franchise taxes may be based on income or a flat amount, depending on the state and type of business.
All businesses pay income taxes. but only corporations pay income taxes directly. These income taxes are based on the profit of the corporation.
Corporations may pay both federal income tax and state income tax if the state has an income tax. Some states require businesses to pay both income tax and franchise tax.
Franchise Taxes vs. Annual Reports or Biennial Reports
Some states have an annual report that businesses are required to file. This report also comes with a fee.
Florida, for example, has an annual report, as does Delaware. Other states, like Iowa, have a biennial (every other year) report that must be filed every other year.
Franchise Taxes vs. Gross Receipts Tax
A gross receipts tax is a tax on sales. It's not taxing the customer but taxing the seller. It's similar to a franchise tax, but it taxes a different way.
Why Franchise Taxes May Not Be Good for Business
A franchise tax is what's called a "privilege" tax, meaning that it is imposed on entities for the privilege of doing business in the state. States that have both franchise tax and income tax makes the effective tax rate in these states higher, and it may have the effect of driving business from the state.
Which States Have Franchise Taxes
The states that currently have franchise taxes are:
- New York
- North Carolina
Some states have eliminated franchise taxes, including:
How States Determine Franchise Taxes
Each state has different criteria for determining what type of business entities must pay franchise taxes, the basis for the tax (either income or capital), and the tax rate.
States base franchise taxes on differing criteria. Each of these descriptions is defined specifically by the state in which they apply. Always check the tax laws in the state or states where you do business do understand your obligations.
Franchise taxes can be based on:
- Income (thus, the franchise tax is really an income tax)
- Value of stock, shares of stock, capital stock, or authorized shares
- Gross assets
- Flat amount, or an amount up to a certain amount of assets
- Tangible property or assets (not including intangible assets)
- Taxable capital (as defined by the state)
- Paid-in capital
- Net worth
- Assessed value of real and tangible personal property or net investment in tangible personal property
- Gross receipts (this tax is really a gross receipts tax)
How Do I Pay Franchise Taxes in My State?
Most businesses (except sole proprietors) must register with the state in which they will be doing business. If you are starting a corporation, partnership, or LLC, you register by filing an application for that specific business type.
Your state will contact you after you have registered your business and generally notify you of what taxes you must calculate and pay. You can also check with your state's department of revenue to determine whether your state has a franchise tax or another annual tax on businesses.
The information contained in this article is not tax or legal advice and is not a substitute for such advice. State and federal laws change frequently, and the information in this article may not reflect your own state’s laws or the most recent changes to the law. For current tax or legal advice, please consult with an accountant or an attorney.