Let’s start with this: no matter what your franchise tax bill says, you probably don’t owe Delaware $75,000.00. Take a breath.
Ok, so, why did you get a bill in the mail for $75,000.00 from the State of Delaware (or your registered agent company)? Delaware franchise taxes. Allow me to explain:
Every year, every Delaware corporation is required to file an annual report and pay what’s called a “Franchise Tax.” Basically, this is the fee that you pay Delaware for the privilege of being incorporated in their state. Much like Massachusetts and many other states, Delaware essentially says to businesses, “We’re not going to make you jump through a lot of hoops or give us a lot of information, just pay us.” So you do.
Franchise taxes are only paid by Delaware corporations, and are due by March 1 each year. If you miss the deadline, they’ll hit you with a $125.00 late fee, and then charge 1.5% monthly interest thereafter, so it’s best to get things filed on time. Limited liability companies and partnerships of all stripes in Delaware pay an annual tax, but it’s just a flat fee of $300.00 every year, without any weird calculations. The LLC tax is also due on a different schedule than the franchise tax, it’s due June 1 each year.
The franchise tax is calculated in one of two ways: (1) the authorized shares method; and (2) the assumed par value method. By default, Delaware sends out your tax bill using the authorized shares method, which is the reason your tax bill is crazy high.
The Authorized Shares Method
When you create a Delaware company, one of the pieces of information you’re required to list out in your Articles of Organization is the number of shares that the company is authorized to issue to shareholders. Particularly with startups, everyone seems to want to authorize millions and millions of shares. The most frequent request I get is 10 million.¹ Leaving aside the propriety of such a request, creating 10 million shares will ensure a large franchise tax bill, and that’s because the authorized shares method of calculation is Delaware’s default.
Using the authorized shares method, Delaware will calculate your franchise tax by charging you:
- $175.00 flat fee if you have 5,000 shares or less; or
- $250.00 flat fee for your first 10,000 shares, AND
- $75.00 fee for every additional 10,000 shares, up to a total tax of $180,000.00
So, if you’ve authorized 10 million shares, you will be charged:
- $250.00 for first 10,000 shares, plus
- $74,925.00 (999 x $75), for the remaining 9,990,000 shares
Leaving you with a total tax bill of $75,175.00, based solely on your authorized corporate structure.
The Assumed Par Value Method
Fortunately Delaware has a second method that it uses to calculate a company’s franchise tax, and the tax you owe is based upon whichever method comes up with the smaller number. For most pre-money startups, you’ll owe the minimum tax under this calculation, or $350.00. To figure this number out for certain in any given scenario, you’ll have to figure out your “assumed par value.”
“Par Value” is a legal concept that means the lowest price for which you as a company are authorized to sell your shares. So if your company has shares of common stock with a par value of $0.001, then you aren’t allowed to sell shares for less than $0.001 per share. If your company issues a new series of stock (like a Series A preferred stock), then those series may have higher par values attached to them that you’ll have to account for.
The basic concept behind the assumed par value calculation is figuring out what the real-world par value of your shares are based upon your company’s assets.
The first step in figuring that out is to divide the dollar value of the company’s assets (as reported on your IRS Form 1120) by the number of shares that have actually been issued to people. The result is your assumed par value per share. By way of example:
- Company has $100,000.00 in assets and 100,000 shares issued to the founders. Assumed par value per share is $1.00.
- Company has $1,000.00 in assets and 100,000 shares issued to the founders. Assumed par value per share is $0.01.
Next, for every authorized share, you multiply that share by either its par value as listed in your Articles, or the assumed par value per share, whichever is greater. So if your assumed par value per share is $1.00, and you have authorized 1,000,000 shares, the assumed par value of your company is $1,000,000.00.
Under this method, the amount of tax you pay is $350.00 per $1M of assumed par value, so you take the assumed par value of your company, divide it by $1M, and multiply it by $350.00, to get your total tax.
This can get a little complicated, so I’ll give you an example of how to calculate this, using numbers that are pretty standard for a brand new company. Here are the assumed facts: early stage company, pre-money, that only has common stock and $5,000.00 worth of assets between cash and equipment. There are 1,000,000² shares authorized, par value $0.001, and 100,000 issued to founders. The calculation looks like:
- $5,000.00 (assets) / 100,000 (issued shares) = $0.05 assumed par value per share
- 1M (authorized shares) * $0.05 (assumed par value per share) = $50,000.00 assumed company par value
- ($50,000.00 (assumed company par value) / $1M)*$350.00 = $17.50
- Total tax is $17.50, but DE charges a minimum of $350, so you pay $350.00
Filing Your Franchise Taxes
Once you’ve properly calculated your franchise tax fees, and checked your math using Delaware’s Franchise Tax Calculator (warning: super old excel sheet), you can now file the correct franchise tax fees and make payment online.
¹Ownership of a company is all proportional, it doesn’t matter how many shares you own. So if there are 10 shares of Company X issues, and I own 9 of them, then I own 90% of the company. Conversely, if there are 10 million shares issues, and I own 1 million, I only own 10% of the Company, and each individual share is essentially worthless. There are good reasons to have more than 10 shares, namely, you want to have a number that is high enough that you can create whatever ownership percentages you want without having to issue fractions of shares, but for a new company I tend to think that anything more than 1,000,000 is wildly unnecessary.
²Another good argument against authorizing millions and millions of shares up front is that depending on the structure of your company, and what things look like at the end of the calendar year, you could still get hit with a big franchise tax bill. For example, assume a company, maybe a service company, that has 100,000 shares of common stock, par value $0.001, issued to two founders, but 10,000,000 shares authorized, and at the end of December they sign a big contract and take an up-front payment of $200,000, which they leave in the company rather than taking it as a distribution, because they are going to need to reinvest it to fulfill the contract. Now the calculation looks like:
- $200,000.00 / 100,000 = $2.00 assumed par value
- 10M *$2.00 = $20M assumed company par value
- ($20M / 1M)*$350.00 = $7,000.00 total tax
It’s not exactly a $70,000 bill, but it’s still way too much to be paying for no reason.