What is a Franchise Tax?
The franchise tax is a levy charged by the government in some US states for the privilege available to the entity to exist and operate within that particular state. The tax is levied on net worth or capital of the entity, and not on the income earned by the entity.
How the Franchise Tax is Calculated?
The states might levy the tax based on the following methods:
#1 – Business Profit Margin Method
Under this levy type, the profit margin is calculated first by subtracting the costs and expenses from the revenue of the corporation and multiplying the margin by a percentage of business done in that state. For example, if a corporation does only 70% of its business in that state then tax will be calculated on a 70% margin. For a corporation that operates entirely in the state will pay franchise tax on 100% of profits. The margin calculated is then taxed as per applicable tax rates of the state.
#2 – Authorized Shares Method
The tax is calculated by multiplying the total number of authorized shares the company has as per its charter by the tax prescribed per share.
Let us understand the above methods by way of examples.
Example #1 – Business Profit Margin Method
A company has earned a revenue of $5,000 during the year. Also, the company incurred expenses of $3,500 to earn revenue. The jurisdictional state levies tax at the rate of 10%.
Calculation of Profit Margin
- = $5,000 – $3,500
- Profit Margin = $1,500
Franchise Tax can be calculated as follows:
- = $1,500 * 10% = $150
Example #2 – Authorized Shares Method
A company has 7,000 of total authorized shares. The state levies a franchise tax of $2 per share.
- = $2 * 7,000
- = $14,000
How do Companies Pay Franchise Tax?
Following steps need to be followed by the company to pay it in the state of Texas:
- Estimation of tax as per the state laws (based on whichever method the state prescribes)
- File the tax report. The report contains the details of the revenue as well as the calculation of tax paid. There can be following types of return:
- No tax due: If the annual turnover falls below the prescribed limit, then no franchise tax will be levied and this tax report can be filed.
- E-Z Computation tax form and Long-form: Based on the annual turnover limits set by the state, the form can be selected
- File public information report. It is a form every corporate is required to file with the state.
- File additional forms if they are applicable to you.
- Prepare and file franchise tax reports with the state.
Franchise Tax vs Income Tax
Companies may be subject to income tax or corporate tax. While income tax is being levied on profits earned by the company while franchise tax does not apply on profits. Instead, the corporate is taxed for the privilege they enjoy to operate in the state.
Income tax is levied as per flat rates for the corporate on their profits. On the other hand, it can either be based on profit margin or share capital.
A corporate will pay income tax only when it has profits and not in case of losses. But it may also be payable in the absence of the profits as the same can be levied on share capital basis also.
Corporate set up or operating in states shall check whether the franchise tax is being levied by that state or not. Also, various types of corporations are exempted from this type of tax. One should check whether they fall within the purview of those exemptions. It is payable annually. It shall be paid without any failure or delay as the same can lead to levy of penalty.
This has been a guide to Franchise Tax and its definition. Here we discuss how to calculate franchise tax with the help of examples, how do companies pay it and its differences from income tax. You can learn more about finance from the following articles –