- Posted on: May 16 2022
By: Ron Diaz [5/16/22]
A common surprise for a new Delaware startup’s management team is the Delaware Franchise Tax. A management team often receives a letter informing it that its new corporation owes thousands of dollars in taxes and often is not anticipated.
Yet the Delaware Franchise Tax is something that founders forming a Delaware corporation need to consider prior to formation since the par value, the number of authorized shares, and the number of issued shares can make all the difference for franchise tax liability.
Many entrepreneurs erroneously assume that if their corporation, limited liability company (LLC), or limited partnership (LP) is not profitable, conducted no business activity, failed to issue shares, or had a very, very short existence, that it would not owe any tax to the State of Delaware. While this might be true for income tax consequences, the Delaware Franchise Tax is owed by all Delaware corporations, LLCs, and LPs unless they are designated as exempt. One such exempt example is a 501(c)(3) tax-exempt corporation (often referred to as a “non-profit”).
As a practicing Delaware attorney, I’ve noticed some startup founders remark about the Delaware Franchise Tax. “Franchise tax, how can I owe a franchise tax when I only have one location or a single business?
That doesn’t make sense to me!” However, like many words or terms in the English language, the term “franchise” can have different meanings depending on the context, including an individual or group’s right to vote.
For a Delaware startup founder, director, manager, officer, principal, or management team, the Delaware Franchise Tax is the tax levied by the state for the privilege of conducting business within or under the laws of the State of Delaware. It can be thought of as an annual registration or annual assessment fee.
The entity owes this tax regardless of whether or not it made any profits, conducted any business, or whether or not the entity had a short lifespan before the decision to dissolve or cancel it occurred. For a Delaware LLC or LP, the annual Delaware Franchise Tax is simple: a $300 flat fee that is due by June 1st of every year for the prior year. So, for 2021, the Delaware Franchise Tax would be due on or before June 1, 2022.
There are two different methods for corporations to calculate the Delaware Franchise Tax: (1) the Authorized Shares Method; and (2) the Assumed Par Value Method. Delaware uses the Authorized Shares Method by default to calculate the Delaware Franchise Tax, which, contrary to popular belief, is not due to nefarious reasons.
In fact, the Authorized Shares Method results in a lower tax consequence in some circumstances and, as a practical matter, Delaware would not be able to properly calculate the Franchise Tax under the Assumed Par Value Method without additional information that a corporate representative would need to provide.
Particularly, the Authorized Shares Method uses the total number of shares authorized by the certificate of incorporation (charter, certificate of formation) and is calculated as follows:
- 5000 shares – $175;
- 5001-10,000 – $250; and
- each additional 10,000 shares is an additional $85, with a maximum annual franchise tax consequence of $200,000.
For additional examples, please see https://corp.delaware.gov/frtaxcalc/.
By contrast, the Assumed Par Value Method takes into account all issued shares, par value, and total gross assets (which is the same value provided for your Delaware Corporation’s annual report and reported to the IRS on its Form 1120 Schedule L for the same year that the report is being filed (i.e., not the total gross assets in January, February or March)).
All that being said, a startup can sometimes lower its Delaware Franchise Tax amount by using the Assumed Par Value Method since total gross assets are part of the calculation. However, depending on the share structure, par value, and total gross assets, the Delaware Franchise Tax may still turn out to be higher than a startup can afford. Keeping in mind a startup’s scarce capital, the minimum annual franchise tax under the Assumed Par Value Method is $400. By way of example, please see https://corp.delaware.gov/frtaxcalc/. Delaware also provides an Excel spreadsheet franchise tax calculator at https://corpfiles.delaware.gov/taxcalc_2018.xls.
After determining the appropriate formula to minimize your corporation’s tax liability, you can select to have your Delaware Franchise Tax recalculated by accessing the Delaware Department of State, Division of Corporations, Delaware Corporation Information System (DCIS) – eCorp Site. It is located at: https://icis.corp.delaware.gov/ecorp/logintax.aspx?FilingType=FranchiseTax. To access it, you will need your corporation’s 7 digit Business Entity File Number and any information required for franchise tax calculations. As a bonus, while you are there, remember to file your Delaware Corporation’s Annual Report, which has to be filed by March 1 of each year and is the same date as when the Delaware Franchise Tax is due. The Annual Report filing fee is only $50.
The Delaware Franchise Tax can be a tricky trap for unwary corporate founders looking to take advantage of being a Delaware corporation. But to be sure that you using the right method to calculate your Delaware Franchise Tax liability, or for any other one of your corporate needs, please be sure to contact a DBL attorney for advice, prior to formation, on structuring your Delaware corporation to avoid any unforeseen and unbearable franchise tax consequences.
Posted in: Business Law