While taxes may not be the most exciting part of running a business, staying on top of them is crucial—especially with tax season just around the corner.
Understanding how franchise taxes work is essential for making informed financial decisions and planning for long-term growth. While the term “franchise tax” sounds like a tax levied against franchises only, it actually applies to independent businesses as well. Different states have varying rules and rates for franchise taxes, so it’s important for all business owners to understand this tax obligation as it applies to them.
What is a Franchise Tax
A franchise tax, also called a privilege tax, refers to “a tax paid by certain enterprises that want to do business in some states” (Investopedia). The purpose of a franchise tax is to generate revenue for the state that imposes it.
In general, businesses that are obligated to pay this tax include:
- Corporations
- LLCs
- Partnerships
- Other business entities (varies by state)
Most franchised businesses will be subject to the franchise tax, but whether they have to pay it depends on their business structure and state laws. Furthermore, a franchisor is typically subject to the franchise tax in the various states where it operates.
How Franchise Taxes Work
The way the franchise tax is calculated will vary by state. Some states will charge a fixed fee, while others base it on business metrics. A few common calculation methods include:
- Business revenue
- Capital stock value
- Net worth or assets
- Taxable capital
- Paid-in capital
- A combination of these factors
Additionally, franchise taxes are not income taxes, so they “do not replace federal and state income taxes” (Investopedia).
States That Impose Franchise Taxes
The following states have a franchise tax:
- Alabama
- Arkansas
- California
- Delaware
- Georgia
- Illinois
- Louisiana
- Massachusetts
- Mississippi
- Minnesota
- Nebraska
- New York
- North Carolina
- Oklahoma
- South Carolina
- Tennessee
- Wyoming
Kansas, Pennsylvania, and West Virginia have discontinued their corporate franchise tax. While some states don’t charge a franchise tax, they likely have other business taxes to consider.
Franchise Tax vs. Other Business Taxes
It’s important to differentiate the franchise tax from other common taxes, such as:
- Franchise Tax vs. Income Tax – While an income tax is based on earnings, a franchise tax applies regardless of profitability. For example, California’s franchise tax is a percentage of net income or $800, whichever is greater.
- Franchise Tax vs. Sales Tax: A franchise tax is a business privilege tax, while a sales tax applies to transactions.
- Franchise Tax vs. Business Licensing Fees – A franchise tax maintains legal status in a state, while business licensing fees allow a business to legally operate in a specific location or industry.
Consequences of Non-Payment
A business that owes the franchise tax but doesn’t pay it could face serious consequences such as:
- Penalties & Interest – Late payments result in fines and accruing interest. To avoid this, businesses should ensure timely payment and remain aware of due dates in their state.
- Loss of Good Standing – Businesses that evade the franchise tax when it’s due could lose legal protections and ability to operate.
- Dissolution or Suspension – Not paying the franchise tax when it’s owed might cause the state to revoke the business licenses for non-compliance.
It’s crucial for businesses to pay applicable taxes on time to avoid severe financial repercussions, ranging from costly penalties that can hinder profitability to the potential shutdown of the business.
Strategies to Minimize Franchise Tax Liabilities
While you certainly don’t want to evade your tax liabilities, there are strategic decisions you can make to minimize the taxes owed, including:
- Choosing the Right Business Structure: Some entities, like sole proprietorships, may be exempt. While most franchises operate as an LLC or corporation to protect their personal assets, a sole proprietorship might be an option for smaller, low-risk franchise operations.
- Registering in Business-Friendly States – Some states are more business friendly than others, meaning that they offer more tax benefits. For example, Nevada, South Dakota, and Wyoming don’t impose a franchise tax or a corporate income tax.
- Utilizing Exemptions & Deductions – Even if they can’t avoid the franchise tax, businesses might be able to utilize “deductions, credits, and exemptions to lower their franchise tax position” and reduce their overall tax burden legally (Investopedia).
Thinking About Owning a Franchise?
Complying with federal and state tax laws is a key aspect to running a successful business. If you become a franchise owner, then it’s important to understand and follow your state’s specific tax rules. When running a business, it’s a good idea to consult with a tax professional for personalized advice.
If you’re ready to get started with franchise ownership, then FranNet is here to help. Our expert franchise consultants will evaluate your goals and skills to match you with the right brand. We’ll walk you through the process from start to finish – at no cost to you! Schedule your free consultation today!