DEMYSTIFYING THE DELAWARE FRANCHISE TAX GAME

Delaware is the preferred state of formation for most large corporations. There are a number of good reasons for this: favorable legal frameworks and experienced judges for corporate disputes, to name a couple. Heavy corporate traffic in a single state also makes it easier for our firm, as corporate legal service providers, to manage corporate maintenance filings in one place. When we consolidate those tasks to Delaware, that allows us to make those filings more efficiently and easily.

Not every aspect of Delaware incorporation is easy, though. Every year, around US tax time (mid-April), we see a spike in worried emails when corporations formed in Delaware receive a notice for tax liabilities like this one:

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This is not a typo! Delaware is claiming that the corporation owes $180,000 in their so-called franchise tax (sometimes called a privilege tax). This is the fee a state charges for the privilege of being a corporation formed in their state. $180,000 is the maximum amount you owe under Delaware franchise tax accounting.

If this is you, don’t fret. Although Delaware talks a mean tax-collector game, they’re really just trying to get you to file an annual report and pay franchise taxes. Read on to learn more. Or, if you need assistance, we can help!

Did I do something wrong?

Let’s get this bit out of the way. When you receive a bill for $180k, the first thing you’re probably thinking is: “Oh Sh!t, I’m in way over my head.” This is particularly true for the folks who bootstrapped their startup’s legal needs to save a little cash. But the reality is that you didn’t do anything wrong. It’s common for startup founders to handle some of the initial administrative tasks on their own, and sometimes that yields results that you don’t understand or foresee. In this case, this is Delaware using your lack of knowledge against you; it’s a sort of a “fool-me-once” situation.

THAT SAID: although there’s some cost associated with it, hiring an experienced attorney early in the startup process is, in most cases, going to save you money in the long run. Your attorney will be able to ensure structuring your business correctly from the outset, avoiding the need for corrective work and filings. Budget for legal as you set up your business—it will save you!

Why do I owe so much in franchise tax?

To answer that, we’ll need to take a look at how Delaware is calculating your franchise tax. They use two different methods depending on whether your corporation’s shares have or don’t have what we call par value.

Par value is an archaic concept that comes from the early days of corporations. Par value is defined as the absolute minimum cash that the corporation could exchange its stock for. In the 19th and early 20th centuries, the par value was disclosed in a corporation’s formation documents as a way of showing the capital it was raising for the venture. So if your corporation authorized 1000 shares at $10 par value, that means that your company, fully diluted, should have at least $10,000 in capital available to distribute to shareholders, assuming the corporation is profitable. This creates some transparency into to the value of the company and your shares in it. The disclosure of a par value also serves as a protection measure: if you get an offer to buy stock in a company for $1 per share, but the company’s stock certificates say par value is $10, then you know something’s wrong. The corporation is either “watering down” the existing shareholders or the venture’s outlook is not quite as rosy as they’d have you think.

Today par value doesn’t really serve those purposes. In the US, closely held corporations typically do not generally solicit stock offerings to the public or disclose their paid-in capital. US securities laws limit a corporation’s ability to make public offerings, and corporations’ equity financing usually occurs in small, private meetings with investment funds. As a result, Delaware at some point allowed for corporations to be created without par value; and, in cases where a corporation does have a par value on its stock, that value is typically nominal (e.g. $0.00001). Corporations still publicly disclose in their formation documents the number of shares authorized to issue to stockholders, but, as it currently stands, par value is really only used to compute your Delaware franchise tax.

With that background out of the way, here are the two ways Delaware calculates your franchise tax:

Authorized Shares Method

The first method they use is mandatory for corporations that have no par value stock, but corporations with par value stock can also use this method if they’d like (see problems with that below). If your corporation has no par value listed for the stock authorized under its charter, then Delaware will charge you based on the number of shares authorized:

  • 5,000 shares or Less: $175

  • 5,001 Share to 10,000 Shares: $250

  • Every 10,000 Additional Shares Above 10,000: $85 for each 10,000

$175 is the absolute minimum in franchise tax you will pay to Delaware per year for a general business corporation (we’re not covering “nonstock” corporations or LLCs here).

Most growth startups seeking investors will not want to fall under this tax-calculation however. After one or two rounds of investment, the corporation will need to issue new classes of stock, and the percentage ownership will need to be divided into very small pieces to ensure that the offering is fair and precise. To illustrate, if my corporation only has 1000 remaining shares to issue out of its 5000 shares authorized, the smallest percentage ownership I can issue is 0.02%. And if my company is worth $10,000,000, the smallest amount of investment I can take is $2500 (assuming I’m not issuing fractional shares). This might be fine for 3-4 stockholders, but becomes seriously unfair when you have to round up or down a share to issue stock for 40-50 stockholders. Consider for a moment the advisor who received 5 shares for $11,500 worth of services to the corporation, as compared against the investor who paid $12,500 for 5 shares. That investor might feel pretty salty!

So if a growth startup wants to issue smaller percentages, it needs to have more authorized shares. And if you want to issue 10,000,000 shares over the first few years of your startup (which is common), under the Authorized Shares Method you’re going to pay:

$250 + (9,990,000/10,000) * $85 = $85,165

And here is our franchise tax problem! So most startups with large numbers of shares will opt for the…

Assumed Par Value Method

This method is a little more complicated but far more common for growth startups. The assumed par value method assumes that each authorized share of stock has a par value equal to its gross assets divided by the number of issued shares, regardless of the par value stated in the corporation’s charter. Delaware then takes the greater of this assumed par value and the actual par value to determine your tax. It’s easier to show you how this works:

A startup has 10,000,000 authorized shares at $0.0001 par value. The corporation has issued 8,000,000 shares of its common stock to the founders and reserved 2,000,000 for issuance to early-stage employees, advisors, and investors. Assuming gross assets of $5,000 (just a few computers and some cash put in by the founders to cover expenses), the assumed par value of each share of the corporation’s stock is:

$5000 / 8,000,000 = $0.000625

That price is your assumed par value (or APV). Take the greater of your APV and the actual par value stated in the corporation’s charter (the APV is higher in this case), and multiply that by the number of authorized shares:

$0.000625 * 10,000,000 = $6250

The number above is called your assumed par value capital (or APVC). The corporation will pay $400 for every million dollars in APVC, rounded up to the next whole million. In this case, the company will owe the minimum of $400 under the assumed par value method. If the company had $1,006,250 in APVC, the company would owe $800 in franchise tax, $2,006,250 would trigger $1200, and so on.

How Delaware Calculates the Tax

Now that we’ve cleared that up (LOL), we need to understand why Delaware is charging so much for its franchise tax to corporations that fail to file their annual reports on time.

So you’ll notice that three numbers matter for your tax calculation:

  1. The corporation’s gross assets;

  2. The number of shares authorized; and

  3. The number of shares issued.

When you don’t file your Annual Report with Delaware (the document that discloses these numbers above), Delaware can’t assume how many shares you’ve issued or the value of your gross assets, so it defaults to the authorized shares method. And then, as noted above, you’ll pay more than $85,000 for a corporation with 10,000,000 shares.

If any of this is unclear, Delaware provides a pretty easy tax calculator for you to use.

So how do I reduce the annual franchise tax?

EZ

First, pay on time.

The deadline for Delaware corporations to file their annual reports is March 1. If you fail to file by that date you will owe a penalty and interest. To file you’ll need basic info about the corporation: name, DE file number, officer/director information, address, and an address.

Second, make sure you issue your shares early!

This is self-explanatory, but it’s a more common problem than you’d think. Founders form their corporations, raise money, issue stock to investors, but never stop to formally issue shares to themselves. This causes a whole bunch of problems for the company’s and the founders’ taxes if not done early in the company’s life. Therefore, as a general rule, founders should issue a good chunk (at least 50% and likely as much as 80%) of their authorized shares to themselves as early as possible (subject to standard vesting schedules). This not only ensures proper franchise tax treatment, but it also ensures that the founders are properly holding a solid chunk of the company’s fully diluted equity, thereby incentivizing them to build value over the long haul.

Third, report the information accurately!

If you’re a startup and you’re still getting something more than the minimum franchise tax on your annual report, consider hiring someone to make sure that your information is correct. You should not be paying more than the minimum tax if you have don’t have any significant assets.

Fourth, if you’re still confused…

…talk to an attorney or an accountant. But in any event, don’t cut a check for $180,000 for franchise tax.

This all seems overly complicated.

That’s not a question, but we see where you’re going. From one perspective, this all seems a bit exploitative. That is, because you don’t know any better, Delaware is scaring people into hiring lawyers and accountants to “fix” a problem that didn’t really exist in the first place. You didn’t do anything wrong, and yet you’re receiving a notice for a massive tax liability. We’ve grown to accept these sorts of collection practices over the years, but something doesn’t feel quite right about misleading a startup to believe that they owe more tax than they actually do.

We would definitely be interested in talking to lawmakers, policy advocates, and stakeholders who would like to contact Delaware’s taxing authorities about these practices and propose a better way. Give us a shout if you’re interested.

JOB POSTING: JUNIOR ASSOCIATE

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