Some states require a franchise tax, which is a tax on businesses operating or chartered within that state's borders.
Depending on the state, the exact name of the franchise tax may vary. Alternative names include: business entity income tax, business privilege tax, business profits tax, commerce tax, corporate franchise tax, net worth tax, and unincorporated business franchise tax.
A franchise tax differs from state income tax, which is calculated on the business's profit. A franchise tax may apply to a business regardless of whether or not it earned any income in the state if it otherwise meets the requirements to file and pay the tax.
Tax Nexus and Franchise Tax
Nexus is a legal term used to describe a connection between a taxing entity, such as a state, and a business entity. If a business has nexus in the state, it has sufficient presence in the state to incur a tax. The state determines the nexus required for a franchise tax, and this varies among the states. The two common methods of determining nexus are whether the business has a physical presence or an economic presence in the state.
A business has a physical presence in a state if it has a physical location, whether it owns or leases property, in the state. Alternatively, it may have employees, such as a traveling sales team, that reside in the state.
A business has an economic presence if it meets the state's threshold for total revenue earned or the number of transactions completed. Even if the business does not have a physical location in the state, it may derive a sufficient amount of income from doing business within the state to satisfy the state's economic presence nexus requirement.
Who is Required to Pay Franchise Tax?
Each state determines what businesses must pay its franchise tax. Some states only require C corporations to pay the franchise tax. S corporations, partnerships, and limited liability companies (LLCs) are also required to pay in other states. Some have taxes specific to unincorporated businesses. Many apply to all business types.
Certain states may exempt an entity based on the type of business it conducts in the state. For example, small incorporated farming businesses are exempt in certain states. It is important to know the specific requirements for the states in which you may have nexus.
States Requiring Franchise Tax
As of 2021, eighteen states impose some form of franchise tax on businesses operating within their borders. The states are Alabama, Arkansas, California, Delaware, Georgia, Illinois, Louisiana, Mississippi, Missouri, Minnesota, Nevada, New Hampshire, New York, North Carolina, Oklahoma, Tennessee, Texas, Vermont, and the District of Columbia. The franchise tax in Illinois will phase out through 2024.
How is Franchise Tax Calculated?
Each state calculates its franchise tax differently. The most common calculation methods are:
- A percentage of the business's net worth
- A percentage of the book value of the business's real or personal property located within the state
- A percentage of the value of the business's capital stock
- A flat fee for all businesses subject to the tax
Minimum and Maximum Limits
Depending on the state, businesses with a net worth beneath a specific threshold may be exempt from the franchise tax. Other states require a minimum franchise tax regardless of whether the business had any income during the year. Some states also set a maximum franchise fee for all businesses over a certain net worth.
Franchise Tax vs. State Income Tax
States with franchise taxes may collect them even if they also have a state income tax. A franchise tax differs from an income tax because it is not based on a percentage of the business's profits. A business with no profit may still be subject to a franchise tax.