March 2, 2011 12 Comments
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.