The State Franchise Tax: Another Business Tax to Consider

Practical SALT Guidance:  Last week I received an e-mail from a business associate. He's a member of a high-technology finance executive group which includes CFOs, finance VPs, and corporate controllers, many whom work for high-tech start-ups. Along with his e-mail, he forwarded a fellow member's question on state franchise taxes.  The question stated that this executive's company was incorporated in Delaware, had operations in Alabama, California, and Missouri, and a single employee working in Tennessee.

My colleague, being well aware of my state tax focus, forwarded the question to me, and I enthusiastically answered it.

I'm often asked about state franchise taxes; many companies don't understand exactly what a state franchise tax is and when a filing is required.  As the executive who posed the question said, "In most small start-ups, you need a whole tax department to keep up with the reporting requirements if the letter of the law were followed in each instance, which isn't practical for many small companies." And like this executive you're probably grappled with whether your company is subject to a state's franchise tax.

But what exactly is a state franchise tax?  Should your company be filing franchise tax returns?  

Despite its name, a franchise tax is not a tax on franchisees.  A franchise tax is a business tax imposed for the privilege of doing business in a state.  Currently, about half the states impose a franchise tax, either in conjunction with, or in lieu of, an income tax.  

Being incorporated in or meeting a state's definition of "doing business" in a state will generally require a franchise tax filing. In tax-speak, we say that a taxpayer's activities in a state have created "nexus" for franchise tax purposes.  While having an obvious physical presence in a state, such as owning or leasing a physical location or having employees who perform their job responsibilities in the state, would certainly create franchise tax nexus, some less obvious activities could also be construed as "doing business".  Hiring independent contractors to fulfill a contract or perform a service, having in-state spot inventory for the convenience of customers even if the bulk of an order is filled from out of state, soliciting sales even if the solicitation is by independent sales representatives or agents, or entering a state to purchase, place or display advertising are all examples of activities that could be considered "doing business" for franchise tax purposes.  

A franchise tax filing may be due even if a company has yet to begin any activity in a state if the company has filed for a Certificate of Authority with the Secretary of State. (Yet another, separate filing requirement.)

And although what constitutes "doing business" for franchise tax purposes can vary from state to state, as a general rule, if a company has sales tax nexus (is required to charge and remit sales tax), the company should be filing a franchise tax return. Finally, while it seems almost certain that even minimal activity will create a franchise tax filing responsibility, because the franchise tax is based on an "apportioned" capital, net worth or other non-income base, the amount of franchise tax that might ultimately be due could be nominal.  

Oh, and the question posed by the technology executive?  Well, as you probably guessed, I advised him that the company had a franchise tax obligation in all five states.

Final Comments and Additional Resources:

Interested in a more in-depth discussion on state tax nexus?  Here's link to "Navigating Nexus", an article published in the November 2011 issue of the Journal of Accountancy. In this article, my co-author and I discuss nexus for all types of business taxes and provide a road map for addressing nexus concerns.

A state's franchise tax is generally administered by a State's Department of Revenue or Taxation.  For more information about your particular state's franchise tax filing requirements, visit your state's website.  You can link to your state's revenue agency website by visiting the Federation of Tax Administrators state tax agency webpage. 

In some states, the franchise tax is imposed only on corporations, while in other states several types of legal entities may be subject to the franchise tax.  For example, the Texas franchise tax is imposed on virtually all types of legal entities, including Subchapter C and S corporations, partnerships, Limited Liability Companies, trusts, professional associations, etc.   Be sure to check whether your entity needs to file.  

Finally, though I've provided a quick overview on this oft-overlooked business tax, state taxes can be complex! So, as I always say, be sure to consult your CPA, tax advisor, or state tax consultant.

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The above post, "The State Franchise Tax: Another Business Tax to Consider", was authored by Sylvia F. Dion, and also appeared in the June 23, 2011  issue of the Business Tax Advisor blog of AllBusiness.com  (see side bar for more about her AllBusiness.com posts.)  It has been expanded upon and reproduced as a State and Local Tax "Buzz" post for the benefit of the "Buzz's" readers.