The “Delaware Franchise Tax” assessed against every Delaware corporation is one of the many mysteries early stage companies encounter. Delaware has become the leading choice to organize as a corporate entity in the United States and has predominantly been the place where many early stage companies or venture-backed companies organize. Inevitably, every early stage corporation will receive a “Delaware Franchise Tax” bill for the first time, or they might receive a bill that is larger than they expect.
The first question often asked by these companies is, “If we are not a franchise, why are we getting a franchise tax?”
Franchise tax is the way that Delaware, which has no state sales tax, manages to generate revenue. Each state generally has a similar fee for using it as the place a company organizes. Therefore, the mystery is not so much that the taxes are due but how the tax is calculated. The calculation usually occurs on or before March 1 when each Delaware corporation is required to file its annual franchise tax report.
The Delaware Secretary of State, Corporation Division usually provides each Delaware corporation a standard tax “invoice” indicating an amount of tax that is due. The real secret is that there are two methods to calculate the tax:
- the authorized share method (the default method used by the State); and
- the assumed par value method (an alternative method that an entity can use to alternatively calculate its tax burden).
This second method will virtually always reduce the amount due – many times dramatically. However, the State of Delaware provides the authorized share method as the amount owed.
The authorized share method (the default method) is based on the number of shares that the company has authorized in its charter. The tax is calculated as follows:
- 5,000 shares or less (the minimum tax $175);
- 5,001 to 10,000 shares ($250);
- each additional 10,000 shares, or a portion thereof ($75); and
- the maximum annual tax ($180,000).
So for example, a corporation with 10,005 authorized shares pays $325 ($250 plus $75), and a corporation with 100,000 shares authorized pays $925 ($250 plus $675 [$75 x9]).
This tax can, based on the authorized share method of calculation, be rather disproportionate and shocking to early stage company budgets. Numerous early stage founders and advisers to companies have been concerned about incorporating in Delaware because of the extraordinary tax burden.
However, the mystery can be unraveled (and the tax bill reduced) by utilizing the assumed par value method. Most early stage companies can substantially reduce their Delaware franchise tax bill to very reasonable amounts. The formula for the assumed par value method uses inputs – including the number of issued (versus authorized) shares, the number of authorized shares per class and their par values, and the corporation’s total gross assets (as reported on a company’s Form 1120-Schedule L of the federal return). This formula calculates an assumed par value and, ultimately, the tax. Most early stage companies can greatly reduce their Delaware franchise tax liability by utilizing this method.
The lesson learned is that when a newly formed or other corporation receives its Delaware franchise tax bill, it should not assume that the amount stated on the face on the invoice is what they would ultimately pay. The Delaware Secretary of State has a very useful calculator that allows Delaware corporations, for their own planning purposes, to calculate hypothetical amounts based on authorized issued and par value and gross assets of the company.
It is important to note that although Delaware is generally seen as the gold standard of incorporating in the United States, understanding the way that a Delaware Franchise Tax is calculated is extremely important so that early stage companies who may authorize a relatively large number of shares can usually greatly reduce the amount that they rightfully owe the State of Delaware.