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The Delaware Franchise Tax: Nicholas G. Tsapralis, CPA, JD, LLM & Vito A. Cosmo, Jr., CPA, MST Most companies are aware that the utilization of a Delaware Holding Company (DHC) can be an effective means to obtain significant state and local tax savings. In addition, most companies are aware that Delaware, because of its favorable corporate laws and business climate, is a preferred state of incorporation. However, prior to forming their DHC or incorporating their business in Delaware, companies should be aware of one of the State's less publicized taxes, the Delaware Franchise Tax. This tax contains traps for the unwary by significantly diminishing any benefits derived from a DHC or by incorporating in Delaware. However, prudent taxpayers may find opportunities to mitigate their annual Franchise Tax liability. IMPOSITION OF TAX The Delaware Franchise Tax, which is an annual tax administered by the Secretary of State, is imposed on domestic corporations for the privilege of "existing" and is generally measured by the corporation's authorized capital stock. In this regard, the tax is imposed on every corporation incorporated under the laws of Delaware and is viewed as an annual tax, for the use of the State, by way of license for the corporate franchise. As a result, foreign corporations (corporations not incorporated in Delaware) doing business in the State are not subject to the Franchise Tax. Delaware's statute does contain a retaliatory tax on foreign corporations; however, in practice this tax has never been imposed.1 Generally, the tax is based upon the corporation's number of authorized shares, subject to a graduated rate structure. The authorized capital stock of a corporation is the total number of shares which the corporation is authorized to issue, regardless of the number of shares that may be issued and/or outstanding at any one time. In addition, there are no provisions for apportionment. The tax is imposed at the full amount, regardless of where the corporation actually does business. Therefore, a corporation which is incorporated in Delaware but has its headquarters and operations entirely outside the state is subject to Franchise Tax to the same degree as a corporation incorporated in and solely doing business in Delaware. Other types of entities Since the Franchise Tax is an imposition for the privilege of incorporating in Delaware, as opposed to an imposition on "doing business," other business entities such as partnerships, common law or "Massachusetts" trusts, limited liability companies and other non-corporate type entities are not subject to the Franchise Tax, even if they are formed in Delaware and treated as corporations for federal income tax purposes. COMPUTATION OF TAX Corporations that are subject to the Franchise Tax are permitted to compute their tax base under one of two methods, and pay tax using the method which yields the lower amount of tax. The two methods are the authorized capital stock method, which is the method of default, and the assumed capital method. AUTHORIZED CAPITAL The Delaware Secretary of State uses the authorized capital stock method to compute a corporation's Franchise Tax liability, which is printed on the Annual Franchise Tax Reports sent to the corporations. As previously discussed, the authorized capital stock method is based on the number of shares of stock a corporation has authorization to issue. The tax due based on the number of authorized shares of stock is as follows:
Corporations that have authorized a nominal number of shares that can be issued are subject to a minimal amount of tax. However, to the extent that a corporation has authorized millions of shares of stock, its Franchise Tax liability could be as high as $150,000. For example, a company with 10,000,000 authorized shares would pay an annual tax of $50,040 ($90 + (9,990,000/10,000 x $50)). Corporations often authorize millions of shares with plans to issue the shares to the general public sometime in the future. Such plans can be costly, especially if the company does not anticipate issuing the shares to the public in the near term. Therefore, taxpayers should consider limiting the number of authorized shares when forming a company in Delaware, because whatever benefits Delaware incorporation may provide, those benefits could be more than offset by a substantial and unnecessary Franchise Tax liability. ASSUMED CAPITAL METHOD The assumed capital method provides two alternate methods for a corporation to compute its Franchise Tax liability, depending on whether the corporation's authorized stock has a par value. This computation assumes that the company used the authorized shares method for the first period and the assumed par value capital method for the second period. When an amendment has been filed during the year, the taxpayer can use either method of computing the tax due for each period, depending on which method results in the lower amount of tax. ASSUMED PAR VALUE Corporations that have authorized par value stock can use the assumed par value capital method to compute their Franchise Tax liability as an alternative to the authorized shares value method. Under this method the corporation must first compute its assumed par value, which is done by taking its total assets as reported on Schedule L of its Federal Income Tax return (Form 1120) and dividing this amount by the total number of issued shares. The resulting quotient is multiplied by the number of authorized shares to arrive at the corporation's assumed par value capital. If the assumed par value capital is greater than 1,000,000, round up to the next million and multiply $200 per million. If less than 1,000,000 divide by 1,000,000 and multiply by $200. Should your assumed par be less than the stated par value, multiply the authorized stock by its respective par value and continue the calculation. For example, assume the following facts:
Based on these facts, the corporation's Franchise Tax liability under the assumed par value capital method would be computed as follows:
By using the assumed par value capital method to compute its Franchise Tax liability, the corporation will owe $800, as compared to the $50,040 in tax it would have to pay using the authorized shares method. Corporations should be aware that the Secretary of State will compute the amount of tax due under the authorized shares method when it sends the annual reports and it is up to the corporation to re-compute the tax under the assumed par value capital method in order to determine if it would yield a lower amount of tax. ASSUMED NO-PAR VALUE Under the assumed no-par value capital method, the corporation must first compute its assumed no-par value capital, which is done by multiplying the amount of no-par authorized shares by $100. The amount of tax due under the assumed no-par value capital method is based on a similar, but different, graduated rate structure as used above. While corporations that have authorized no-par value stock can use the assumed no-par value capital method to compute their Franchise Tax liability as an alternative to the authorized shares method, there is no advantage in doing so since the tax computed under either method will be the same. Thus, a corporation that wishes to have the ability to reduce its Franchise Tax liability below that computed under the authorized shares method should consider authorizing stock with a par value. PLANNING OPPORTUNITIES In certain circumstances, corporations may reduce their Franchise Tax liabilities over and above the amounts resulting from a favorable computational method, as discussed above. In this regard, first-year or last-year corporations, inactive corporations and corporations that changed the amount of authorized shares during the tax year may utilize the planning opportunities set forth below. PRORTATION OF TAX A corporation normally computes its Franchise Tax based upon an annual existence. However, a domestic corporation which has not been in existence for an entire year may prorate its Franchise Tax to reflect its short-period existence. Where a corporation has not been in existence during the whole year, the amount of tax due will be prorated for the portion of the year during which the corporation was in existence. For instance, a corporation, which was incorporated on December 17th, would compute its tax based upon the normal requirements of either the authorized shares method or the assumed par value capital method. The corporation would then prorate the computed tax liability amount based upon the number of days of its existence, 15 days in this example, divided by 365 days. A corporation utilizing this provision can substantially reduce its liability in its first or last years of existence. Change in Authorized Shares Corporations that have changed the amount of authorized shares by filing an amendment with the Secretary of State are also able to prorate the tax computation to reflect each amendment filed. Using the previous example, assume the following facts:
INACTIVE CORPORATION A seldom-used provision is the Delaware Code Ann. Tit. 8, Sec. 503(f), which entitles an "inactive corporation" to a rate of one-half of the amount of its computed Franchise Tax. Successful utilization of this provision will ultimately depend upon the corporation's facts and circumstances related to its corporate purpose. In this regard, the corporation must show that it had not been engaged in any of the business activities for which it was granted a certificate of incorporation. The corporation may be required to submit a supplemental affidavit stating fully the pertinent facts upon which the claim for the one-half rate was based. GROSS ASSET REDUCTION Often, because a corporation has high gross asset values, the alternative calculation under the assumed par value capital method may not yield a significantly lower liability. Therefore, taxpayers may want to consider converting high gross asset values to lower values by contributing such assets and related disabilities to a newly formed Delaware subsidiary corporation which has a nominal number of authorized shares. Of course, taxpayers should be careful that other state transfer or transaction taxes are not triggered in such a restructuring. PAYMENT OF TAX The period for which the Franchise Tax is based is a calendar year and the Annual Franchise Tax Report is due by March 1 of the succeeding year.2 For example, a corporation's 1996 franchise tax will be for the period January 1 through December 31, 1996 and the report will due on March 1, 1997. If a corporation estimates that its Franchise Tax liability for the year will exceed $5,000, it is required to make tentative payments as follows:
Any remaining tax would be due on March 1 of the succeeding year with the filing of the Annual Franchise Tax Report. REFUNDS Delaware permits a corporation to file a petition for refund with the Secretary of State if it believes that the tax, interest or penalty with respect to the Franchise Tax liability for a given year was illegally or erroneously fixed or paid. A petition for refund must be filed with the Secretary of State no later than March 1 of the 2nd calendar year following the close of the calendar year to which the refund claim relates. For example, a petition for refund with respect to a corporation’s 1995 Franchise Tax liability must be filed by March 1, 1997. Since the report for the 1995 year is due on March 1, 1996, a taxpayer would have one year to file a petition for refund. Due to the short time frame in which to file a petition for refund, corporations should carefully review their Franchise Tax filings each year to ensure that they are paying the correct amount of tax. 1While foreign corporations are not subject to the annual franchise tax, they are required to file an annual report with the Secretary of State and pay a $30 filing fee. 2In addition to the computed tax amount, corporations are also required to pay a $20 filing fee with the return. Accordingly, the minimum amount that a domestic corporation will have to pay with its annual franchise tax return is $50, the minimum tax of $30 plus the $20 filing fee.
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LETTER FROM THE EDITOR: Delaware Management Services (DMS) is pleased to provide you with the inaugural issue of, First State Informer, a periodic newsletter dedicated to providing you with timely information and discussion of issues pertaining to Delaware Holding Companies as well as other alternative Delaware entitics. In this issue, our article focuses on planning for the minimization of the Delaware Annual Franchise Tax. Nicholas G. Tsapralis of KPMG LLP and Vito A. Cosmo, Jr. of PricewaterhouseCoopers LLP identify the pitfalls associated with not planning for this tax. They summarize the basis for tax, the various methods of computing the liability, the steps taxpayers can take to minimize the tax liability and the procedure for filing a petition for refund, where applicable. DMS is delighted to be celebrating its tenth year of providing superior corporate management services for clients nationwide and happy to have the opportunity to serve you and your clients. We hope that you will find the articles contained in our newsletters informative and useful in your practice. Please call us at (302) 477-1260 or (888)4-DELMGT if we can be of any assistance. In addition we invite you to explore our website (http://www.delmgt.com) and learn more about the comprehensive services provided by the DMS team and to take advantage of our on-line library.
ABOUT THE WRITERS: Nicholas G. Tsapralis is a Philadelphia-based senior manager with KPMG's State and Local Tax Practice. Mr. Tsapralis holds Master of Laws and Juris Doctor degrees from Villanova University School of Law and a Bachelor of Arts (Honors) degree from Loyola University of Chicago. He is also licensed in Pennsylvania to practice as a certified public accountant. Mr. Tsapralis serves as engagement manager concerning income and franchise tax matters for clients engaged in the financial services and telecommunications industries. His primary focus is on managing State Tax Minimization* projects that assist clients in minimizing their state taxes. Mr. Tsapralis also assists clients with contractual registration matters, refund claims and assessment appeals. Mr. Tsapralis has over seven years of experience in delivering state and local tax services. Mr. Tsapralis is a member of the American Institute of Certified Public Accounts - Tax Division, the Pennsylvania Institute of Certified Public Accountants and the Philadelphia Bar Association - State and Local Tax Committee. Vito A. Cosmo, Jr., a Multistate Tax Consulting Principal Consultant (Senior Manager) in the Philadelphia, Pennsylvania office of PricewaterhouseCoopers LLP, holds a Master of Science degree in Taxation from Widener University and a Bachelor of Science degree in Accounting (magna cum laude) from Albright College. Mr. Cosmo is also licensed by the Commonwealth of Pennsylvania to practice as a Certified Public Accountant. He joined the firm in 1993. Mr. Cosmo has obtained a well rounded experience in all aspects of multistate tax consulting, including planning, research, compliance and protest proceedings for large and medium sized companies. Mr. Cosmo has extensive planning and protest experience in Pennsylvania Capital Stock/Franchise Tax, Pennsylvania Corporate Net Income Tax and Philadelphia Business Privilege and Net Profits Taxes. Prior to joining the firm, Mr. Cosmo was a manager in a local accounting firm for seven years, where he was responsible for both federal and state tax compliance and planning. Prior to this experience, Mr. Cosmo was an audit senior with another "Big Five" accounting firm for two years. Mr. Cosmo has been an adjunct professor of accounting and taxation at Delaware Valley College in Doylestown, Pennsylvania for the past ten years where he teaches courses in individual and corporate taxation. He is also a member of the Tax Division of the American Institute of Certified Public Accountants where he has served as a Division Director of Government Relations and as a member of the Executive Committee for the Greater Philadelphia Chapter. The name "Delaware
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