Beware, Delaware Franchise Tax Bill Ahead

 

Welcome to Delaware, please pay us $22,575

While Delaware is a good choice for where to incorporate your business, there are a few things they do that kind of piss us off.  Calculating franchise taxes is one of them, or in particular, their default method for calculating franchise taxes and how they present this bill to corporations.

At some point after you incorporate in Delaware, you will receive an innocuous looking envelope with a bill enclosed for your Franchise Taxes.  It will be shockingly high – the highest any of us have seen for a seed stage company was about $75,000!  While Delaware would be more than happy if you paid this bill and forgot about it, the reality is you likely do not own anywhere near the amount shown, so don’t panic.

Here is what happened - There are two ways to calculate the Franchise Taxes owed for Delaware Corporations, the Authorized Shares Method and the Assumed Par Value Method.

Method #1 - The Authorized Shares Method is easy to calculate, and Delaware has this information from your corporate filings, so defaults to it.  It also happens to be the process that almost no company formed with the intention of raising venture capital and going public one day will ever use.  The process is simple and explained below:

If your entity has 5,000 authorized shares or less, the Franchise Tax is $75

If your entity has between 5,001 – 10,000 authorized shares, the Franchise Tax is $150

For each additional 10,000 authorized shares add $75

So, you started a new business and are planning to make it big one day.  Using the standard approach with attorneys for early-stage startups (an approach we agree with), you decide to authorize a large number of shares at the formation of your business, in this case, lets assume you decide to authorize three million shares of common stock when you incorporate.  Sounds good.  So, lets calculate Franchise taxes using the Authorized Shares Method.  First 10,000 shares, $150.  Check.  Next 2,990,000 shares, an additional $22,425.  Wait a minute.  You just started a business, have no revenues (or even expenses) yet, and you already owe $22,575 in taxes simply because you decided to authorize 3 million shares of stock?

Yes, if you follow how Delaware calculates Franchise Taxes as a default.  But don’t have a heart attack when you get a little envelope from the State of Delaware saying your Franchise Taxes are due and you owe them $22,575.

You don’t owe this money because you will be using……

Method #2 – The Assumed Par Value Capital Method – aka – the method you will always use unless you are a small business with very few authorized shares.

To be fair to Delaware, they do not have the information necessary to calculate Franchise Taxes using this method, so they cannot do it as the default.  And, if you read your $25,575 bill you will see that they explain this alternative method to you (we have been told there are a meaningful number of people who pick up the phone and start screaming before they read the details, but this added cost to Delaware is financially offset by the small number who pay the bill as presented, which we assume the folks in DE love).

The calculations for the Assumed Par Value Capital Method are more complex in that you have to calculate “assumed par value”.  Trust us, it is worth the effort.  Simply put, the tax rate for this method is equal to $350 for every $1 million in “assumed par value capital”.

First, you need the following pieces of information:
(1)  Number of Issued shares (including treasury shares)
(2)  Number of Authorized shares
(3)  Par value for shares (if you have different shares with different par values, you will need the number of Authorized Shares for each par value amount).
(4)  Total Gross Assets (as reported on Form 1120, Schedule L of your Federal Return)

Using this information we’ll walk through an example using the Assumed Par Value Capital Method.

Let’s use an example where the company has $250,000 in Gross Assets, and has the same three million shares of stock authorized.  Let’s assume that 500,000 of these shares are actually issued to shareholders (the rest being authorized but unissued).  Further, lets assume the par value for the stock is $.01 per share (see our post on setting par value for common stock, and note that $.01 used in this example is two decimal points off of where we recommend you set par value).

Step 1:  Calculate your Assumed Par.  This is Gross Assets divided by Issued Shares, carried to six decimal places.  In this example, the result is $.500000.

Step 2:  Multiply the Assumed Par by the number of Authorized shares that have a par value BELOW the Assumed Par calculated above.  In this example that would be all of your Authorized Shares.  The result is $1,500,000.

Step 3:  Multiply the number of Authorized Shares with a par value ABOVE the Assumed Par figure calculated.  In this example there are none, so the result is $0.

Step 4:  Add the results from #2 and #3 to determine the Assumed Par Value Capital.  In this example the result is $1,500,000

Step 5:  If Assumed Par Value Capital is greater than $1 million, round the figure up to the next nearest million.  If the figure is less than $1 million, you do not need to round up as you’ll be paying the minimum amount using this method of $350.  In this example we round the $1,500,000 up to $2,000,000.

Step 6:  Divide the Assumed Par Value Capital by $1,000,000.  The result in this case is 2.

Step 7:  Multiply the result from Step Six by $350.  In our example the calculation will equal $700, which is the amount due to Delaware for Franchise Taxes using the Assumed Par Value Capital Method.

So, to summarize:

Authorized Shares Method = $22,575 in Delaware Franchise Taxes

Assumed Par Value Capital Method = $700 in Delaware Franchise Taxes

Quick Note – In this example you could have saved $350 if you had only Authorized 1,000,000 shares of stock in the first place.  If your attorney puts a big number of authorized but unissued shares in the formation documents, ask them why you need to put them in now instead of authorizing an increase later on when they are needed.  The attorney will tell you it is easier (for them) this way, but will have no idea it could cost you money in Franchise Taxes (they are not accountants, they are attorneys).  Not to be penny wise and pound foolish, but if you raise outside capital down the road you’ll be authorizing more shares anyways, so why not add more then instead of having them sitting around collecting dust (and Franchise Taxes)?

Second Quick Note:  Delaware (and some other states) allow corporations to issue stock with no par value assigned.  This is a BAD idea.  The reason is that you are then forced to use the Authorized Shares Method, which as shown above can get very expensive very fast.

Third Quick Note:  If you want to do things on the cheap, consider authorizing less than 5,000 shares to start and plan to split these by a huge factor when you raise outside capital and want the capitalization to look like most other start-up companies with outside investors.  The one benefit to the Authorized Shares Method is that the minimum tax is $75, compared to $350 for the Assumed Par Value Capital Method.  Not much of a savings (see above note on pennywise and pound foolish), but if you really want to save a few bucks you can consider it.  We’d argue it is more headache than it is worth unless you never plan to raise outside money, in which case you might as well keep the number (and resulting tax) small.

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12 Responses to Beware, Delaware Franchise Tax Bill Ahead

  1. John Zicker says:

    We just went through this with our attorneys as part of selling a company. The information in this article saved us $180,000 in taxes. By far the most valuable blog post I’ve ever read.

    • CapGenius says:

      Wow! Thanks for the comment, information and kudos. We’ll keep adding more content that hopefully helps although $180k will be a high bar for us to beat!

  2. Pingback: Which State should you Incorporate in? Delaware. « capgenius

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  6. Siva says:

    Hi Capgenius! Thanks a zillion for for writing this article at this time… I just received the innocuous looking envelope from DE and it sent my heart rate up. Luckily before I picked up the phone and started yelling at someone I decided to google it. That and a few clicks on the calculator later, heart rate is back to normal and someone somewhere is blissfully oblivious that their day could have taken a turn for the worse…

    Anyhoo, my question is this… now that I have computed my estimated tax to be $350 (per the assumed par capital method) compared to the $45K bill that I got. What do I do next, if I just send in $350 with that bill, will DE figure out what has happened or will they penalize me? There are no checkboxes anywhere to show that I used a different method to compute. So how do I pay the state of DE and ensure they dont start computing interest on the unpaid part of $45K?!! Please help.

    Thanks again!

    • CapGenius says:

      Siva:
      Thanks for your comment and we are thrilled that the post was helpful.

      In terms of filing with the new calculations – you should be able to go through the DE online payment system (https://delecorp.delaware.gov/eCorp/LoginAnnualReportsCLF) and enter in the information including the data necessary for the Assumed Par Capital Method. If for some reason this does not work, we would recommend you place the phone call after all, but fortunately instead of having to go ballistic on someone you can just tell them that you want to pay the Franchise Tax using the alternative method and get the details from them.

      Please let us know if the online payment approach works – a follow-up comment so future readers know how to do this would be appreciated.

      We hope you enjoy your “newly found” $44,625!!!

  7. Pingback: While registering a C Corp. (in Nevade), how many shares of common and preferred stocks one should issue and at what par value? And out of those initially issued, how many shares should a founder held? - Quora

  8. Pia Owens says:

    This is a great, informative post. I’m a startup lawyer and it’s always tough to explain this to clients (who definitely don’t want to pay me to explain it to them!) Next year before taxes are due, I will point them toward this blog post. Thanks!

    • CapGenius says:

      Thanks – much appreciated!

  9. rk says:

    Hi, I’m in a process of incorporating in DE as a S-Corp and having a hard time deciding how many shares to issue. My co-founder and I just started the company, so we don’t want to make a mistake that we will regret down the road. From the research I’ve done, I’ve read comments about issuing 10MM or 20MM when filing. Is this wise especially with the DE franchise tax bill?

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