All Delaware corporations have to pay an annual franchise tax to the state. If you’ve received a notice from the State of Delaware saying that your small startup owes tens of thousands of dollars in franchise tax, do not panic. There are two different ways of calculating Delaware franchise taxes, and Delaware defaults to the one that is usually far more expensive than the other.
Authorized Share Method
Delaware’s default method of calculating annual franchise tax is based only on how many shares a Company has authorized in its charter:
- 5,000 shares or less (minimum tax) $175.00
- 5,001 – 10,000 shares – $250.00
- Each additional 10,000 shares or portion thereof add $75.00
- Maximum annual tax is $180,000.00
By way of illustration for how quickly this grows, a company with 5,000,000 authorized shares will owe $37,675.00; a company with 10,000,000 will owe $75,175.00; and for a company to hit the maximum tax, it will have to authorize just fewer than 24,000,000 shares. Again, this is based on authorized shares and not outstanding shares.
Assumed Par Value Method
This method calculates how much tax is due with a more complicated function based on how many shares are authorized, how many shares are issued, and the amount of a company’s gross assets. The idea behind this method is that it takes a company’s “par value” per share times the number of shares it has authorized (i.e. the total market capitalization), rounds up to the nearest million dollars, and takes 0.035% of that as the tax.
Since most companies set par value very low in their certificates of incorporation (e.g. $0.001 or below), Delaware has come up with an “assumed par value,” which is the Company’s gross assets divided by all of its issued and outstanding shares. The gross assets come from U.S. Form 1120, Schedule L tax form for the same year that the Company is filing its annual report. If the Company has not filed its taxes for that year yet, then a number from a recent balance sheet will suffice and can be amended later if necessary. The par value used to compute the tax is the greater of the “assumed par value” or the actual par value listed in the certificate of incorporation.
Reducing Franchise Taxes
Startups can usually minimize franchise taxes by using the Assumed Par Value method, since it calculates tax as a function of total assets. The only pitfall to watch out for is that even a company with few assets could potentially owe very large franchise taxes if it authorizes a very large number of shares but then issues a tiny percentage of them. So long as your issued shares constitute at least a third to a half of your authorized shares, the Alternative Par Method should work well for most startups.
Be Sure to File Your Annual Reports
For Delaware corporations, franchise taxes are due March 1st of every year for the previous calendar year. A company must pay its taxes by filing an annual report with the Secretary of State of the State of Delaware. You should file the report online. An officer of the company must enter and confirm the necessary information, which includes the physical address/location of the corporation, address of the registered agent in Delaware, a list of all directors and at least one officer, issued shares, and gross assets. The online form will also calculate the correct franchise tax for you. The online form defaults to the Authorized Share Method, but if you fill in gross assets it will use the Assumed Par Value method.
The actual payment of taxes is done with a credit card. If a company owes more than $5,000 in franchise taxes, then it must make quarterly tax payments. Those are due at the end of the second month following each quarter (i.e 40% due on June 1, 20% due on September 1, 20% due on December 1, and remainder due on March 1), and any positive balance goes towards next year. Failure to file by the deadlines will cause a company to fall out of good standing with the state, which can complicate, delay or even prevent a range of possible transactions, including fundraising transactions.