3 Common Questions About Franchise Taxes Answered

Business.com / Accounting / Last Modified: February 22, 2017

Many new corporate owners often ask me to explain what franchise taxes are, and why their business is being forced to pay it.

First-time corporate founders are often a bit stunned at the various taxes, regulations, and fees that they have to contend with as the owner of a new business, and franchise taxes are chief among the more confusing obligations. Around half of all states collect franchise tax, and yet so few people have actually heard of a franchise tax. Not wanting to give the state any money they don't have to, many new corporate owners often ask my company to explain what a franchise tax is, and why their business is being forced to pay it. To clear up some misconceptions about franchise taxes, I decided to write up a quick FAQ for the three most common questions I get asked.

What is a franchise tax?

Because many of us have a clear idea of what a franchise is, the phrase 'franchise tax' can be a bit misleading. A franchise is commonly known as a sort of agreement between an independent operator and a larger corporation. The independent operator pays a fee and, in return, the corporation allows that operator to use their business model, branding, and products. McDonalds, for example, is one of the most successful franchised businesses in the world. But if you aren't running a McDonalds, why do you have to pay state franchise tax? Well, a franchise is actually more of an authorization to do something. In the case of the franchise tax, you are essentially paying a fee to the state for the right to run your corporation within its borders.

Related:How to Handle 5 Common Entrepreneurial Obstacles 

Do I have to pay the franchise tax?

That mainly depends on what states you choose to do business in. Some states, like Wyoming or Nevada, don't have a franchise tax at all, while others, like Delaware or California, have a very steep franchise tax. Unfortunately, you cannot incorporate in a state that doesn't have one and then operate in a state that does in the hopes of avoiding paying the tax. If you have a nexus (a perceived presence) in a state that collects franchise tax, that state is going to want its money. The nexus point for franchise tax collection is also typically lower than the nexus for income tax -- usually, if you collect sales tax for purchases made within a state, you are going to have to pay that state's franchise tax.

How do I figure out how much I owe?

It's a little frustrating, but there are no standardized laws for franchise tax collections. Typically those states with a high franchise tax charge a lower corporate income tax, and vice versa.  California has a minimum franchise tax of $800, with the amount going higher depending on income earned in state -- new corporations, however, are usually exempt from paying California's franchise tax during their first year. Delaware, on the other hand, collects based on the number of shares a corporation is authorized to issue, and collects a flat franchise tax of $250 from LLCs. It's up to you to sit down with your accountant or another professional and see what your obligations are.

Related:The $500,000 Tax Deduction That Business Owners Need to Know About

Franchise taxes are still a bit controversial, and some states have moved to repeal them. Still, many other states depend on franchise tax dollars to shore up a significant portion of their budget, and not paying your franchise taxes could get you some serious fines. Before you incorporate, consider everything you have to pay to the state first. The same goes for doing business across state lines -- if you pass that nexus point, you could be on the hook for a lot of money. Carefully and meticulously research each state you'd like to do business in. The ease of your first few years of business will depend heavily on you how well you know, and adhere to, all of your legal and financial obligations.

(Image via freedigitalphotos.net

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