How to Save Thousands if You’re a Startup [Delaware Franchise Tax]

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The Delaware Franchise Tax is the tax that a company pays to the State of Delaware for the privilege of owning a franchise in the state. This allows businesses to remain in good standing with the state, which can be very beneficial for them. Not knowing the due date (it’s March 1st, by the way) or how to pay are not the only issues you can run into when using the Delaware Franchise Tax. In fact, not fully understanding the math behind the Delaware Franchise Tax can cost your business big dollars.

So let’s break it down.

 

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Let’s start with a common scenario.

After talking to a few friends and your accountant, you decide to run your startup business through a Delaware corporation. You believe that you can do this easily and all by yourself via an online provider. You enter your name, appoint a registered agent, and check the “general business activities” option.

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Next, you pick the number of shares of common stock the company will be authorized to issue and set a par value. You give this a few moments of thought – you plan on issuing some shares soon in connection with your friends and family round. One or two people are interested in investing in a few months, likely in the form of a convertible note.

 

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The company will want to approach employees in the next twelve months and will want to set up an option pool. You decide to set the authorized number of shares at 1,000,000 and select a par value of $0.001. One click and you have completed the company’s setup. Congrats! Now that that simple process is done, it’s time to look at how the Delaware Franchise Tax will cost you more than it should.

 

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A few months later, you get a notice from Delaware stating that you must file the company’s annual report and pay the company’s franchise taxes. The taxes are due by March 1st, regardless of whether or not the company has conducted any business. All you have done so far is issue 100 shares to yourself in exchange for a nominal purchase price. You look at the form and are shocked to see that it says the company owes $7,675.00 in taxes! The company is still pre-revenue and just does not have the funds to pay the taxes due. How did this happen? What do you do? Is the company sunk before it even starts?

 

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Because Delaware fills in the amount of default tax due, most people do not realize that they may have two different methods available to them to calculate their franchise taxes. The “authorized shares method”, the default method used by Delaware, calculates tax due on a sliding scale basis. Delaware assesses a flat fee (minimum of $175) based on the number of shares authorized as follows:

  1. 5,000 shares or less: $175.00
  2. 5,001 to 10,000 shares: $250.00

If the company has more than 10,000 shares authorized, the tax increases by an additional $75 for each additional 10,000 share increment, with a maximum tax due of $180,000.00. In your situation above, you are looking at an annual franchise tax of $250 + ($75 x 99) = $7,675.00!

 

How the Assumed Par Value Capital Method Can Save Your Business

Fear not, there is a way to avoid this. Delaware also accepts an alternate way to calculate taxes – the “assumed par value capital method”. This calculation is more complex, and requires you to disclose the number of issued shares as well as the company’s total gross assets for the relevant fiscal year (as reported on the company’s Federal Return U.S. Form 1120). Calculate the tax as follows:

  1. $350.00 for each $1,000,000 in total gross assets (or portion thereof, for a minimum tax of $350), or
  2. If the company’s assumed par value capital is less than $1,000,000, by dividing the assumed par value capital by $1,000,000 and then multiplying the result by $350.00.

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Let’s run this calculation with your hypothetical company that we talked about above. You are the company’s sole shareholder, so the issued shares are your 100 shares of common stock. Remember, you paid $100 in exchange for your 100 shares. That $100 is the company’s total gross assets. Now calculate the assumed par value by dividing the total gross assets by the number of issued shares ($100/100= 1). The assumed par value capital is equal to the sum of:

  1. The assumed par value multiplied by the number of authorized shares having a par value of less than the assumed par (1 * 1,000,000 = 1,000,000)
  2. The number of authorized shares with a par value greater than the assumed par multiplied by their respective par value (0).

In this case, the “total assumed par value capital” is equal to the number of authorized shares. To calculate the final tax due, just divide that number by $1,000,000 and multiply that result by $350.00 (which looks like this: (1,000,000/$1,000,000) * $350 = $350). The tax due using the assumed par value capital method is a measly $350. Sounds a lot better than $7,675, no?

 

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While the alternative method calculation is more likely to give you a headache (or several), it will often result in much lower taxes due. A general rule of thumb is to go with the default method if you have authorized a fairly conservative number of shares, or if you have elected to have no par value stock.

But, if you, like you hypothetically did in the example above, authorized a large number of shares, the “assumed par value capital method” is the way to go. Another approach might be to consult an attorney before incorporating to make sure that you select the right entity for your purposes, and set it up correctly.

Are S.A.F.E. Notes or Convertible Notes better for your startup? Read this article to learn about the pros and cons of each.

More importantly, forming a legal entity is a big step. If your business and product plans are still on the back of a napkin, think about using a Founder Accord until you are further along.

The author wishes to thank Raji Kochhar of McCormick & O’Brien, LLP, for her contributions to this article.

Charles F. McCormick

Contributor

McCormick & O’Brien, LLP, Co‐Founder Charles F. McCormick has gained national and international recognition for his expertise representing members of the investor and entrepreneurial communities building great companies. Since its founding in 2004, McCormick & O’Brien, LLP has been a key partner to some of the leading investors and entrepreneurs in the media, technology, life sciences, internet and mobile industries. Charles has played in important role in the recent ascendancy of the NYC area as a premiere venue for capital formation and entrepreneurship, and he has helped numerous international emerging companies enter the U.S. market
and establish themselves in the U.S. Charles is the publisher of the Founder Accord, which is a basic deal sheet among founders that sets a new entrepreneurial industry standard for protecting founders while they develop their ideas and grow their businesses. He is also the author of: “What SAFEs Might Actually Tell Us About the Angel Financing Market” and “The Princess Di Problem of Convertible Note Financings.”