What is Franchise Tax?
A franchise tax, also known as a privilege tax, is a tax paid by certain companies that wish to conduct business in specific states. It gives businesses the ability to be chartered and to operate within the said state. Nonetheless, a franchise tax is different from a tax given to franchises, as well as federal or state taxes.
- A franchise tax must be paid by enterprises that wish to conduct business in certain states.
- Franchise tax applies to corporations, partnerships, and many limited liability companies but does not apply to fraternal organizations, non-profits, and some limited liability corporations.
- Franchise taxes are not the same as income tax, as they are not based on business profits.
Understanding Franchise Tax
A franchise tax is a tax imposed on companies that wish to exist as a legal entity and do business in particular areas in the U.S. In 2020, some of the states that implement such tax practices are:
- New York
However, some states no longer impose the franchise tax, including:
- West Virginia
Franchise taxes are charged to corporations, partnerships, and other corporate entities such as limited liability companies. However, franchise taxes do not apply to fraternal organizations, non-profits, and some limited liability corporations. Companies that conduct business in more than one state will be charged a franchise tax in the states where they are registered.
It is important to make note that franchise taxes do not replace federal or state income taxes. They are simply add-on taxes in addition to income taxes. Much like any other tax, franchise taxes must be paid annually as well. The amount that must be paid differs by the tax rules that govern each state.
For example, some states calculate franchise tax based on the corporate entity’s assets or net profits, while others base it on the company’s capital stock. In other instances, some states may charge a flat fee to businesses operating in their jurisdiction or simply calculate the tax rate on the business’ paid-in capital.
How States Determine Franchise Taxes
Despite mentioning briefly above, each state bases its franchise tax on different criteria. The following list below is more extensive:
- Par value of a stock, shares of stock, or authorized shares
- Gross assets
- Flat fee rate
- Net worth
- Paid-in capital
- Real and tangible personal property or after-tax investment on tangible personal property
- Gross receipts
Although companies usually have to pay franchise tax based on where they are operating and registered in each state, sole proprietorships are not often subject to franchise taxes. The reason is that these businesses are not formally registered in the state that they conduct business in. Additional entities that are not subject to franchise tax are:
- General partnerships where direct ownership is of non-legal nature
- Real estate mortgage investment conduits (REMICs) and certain real estate investment trusts (REITs)
- A trust that qualifies under Internal Revenue Code Section 401(a)
- Unincorporated political committees
- Certain grantor trusts, escrows, and estates of natural persons
- A trust that is exempt under Internal Revenue Code Section 501(c)(9)
Franchise Tax vs. Income Tax
There are several differences between a franchise tax and income tax. For example, franchise taxes are not based on business profits, while income taxes are. Regardless of whether profit is made, a business made pay franchise tax, whereas income tax and the amount paid is based on the organization’s earnings during that particular year.
Moreover, income taxes are applied to companies that gain income from the specific states listed above, even though their business does not operate within those boundaries.
The definition of operating may vary by state. For example, selling or offering their services and goods in a specific state or having employees live there may be considered operational for various jurisdictions.
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