What expense category is Franchise Taxes?

Many states impose "franchise taxes" on businesses operating within their borders. Unlike income taxes based purely on profit, franchise taxes are often levied for the mere privilege of doing business or existing as a legal entity (like an LLC or corporation) in the state. These taxes can be calculated based on various metrics, such as net worth, capital stock, gross receipts, or sometimes even a flat fee.

Understanding how to properly categorize these state-levied franchise taxes is important for accountants and SMB owners, as it allows for accurate financial reporting and federal tax deductions.

Franchise Tax Expense Category

Franchise taxes imposed by state or local governments on a business entity are generally considered operating costs.

• Primary Category: The most common and appropriate category is Taxes and Licenses. For clarity, it is recommended that you use a specific sub-account like "Franchise Tax Expense" within this category.
• Other Possibilities: Less commonly, they might be grouped under Operating Expenses or General & Administrative Expenses.

IRS Publication 535 explicitly states that corporate franchise taxes are generally deductible as business expenses. This principle typically extends to franchise taxes levied directly on other business entities like LLCs and partnerships for the privilege of doing business, provided the tax isn't functioning purely as a state net income tax (which has different rules for pass-through entities/sole proprietors).

Some Important Considerations While Classifying Franchise Tax Expenses

When dealing with franchise taxes, keep these points in mind:

1. Nature of the Tax (Privilege vs. Income): It's crucial to understand how the specific state calculates the tax. Is it based on net worth, capital, assets, gross receipts, or a flat fee (generally treated as a deductible business/privilege tax)? Or is it based purely on net income (potentially treated like a state income tax)? State law dictates the tax's nature.
2. Entity Type Matters:
   
   • Corporations (C-Corps & S-Corps): Franchise taxes imposed directly on the corporation are generally deductible by the corporation on its federal return (Form 1120 or 1120S).
   • Partnerships & LLCs (taxed as Partnerships): Franchise taxes imposed directly on the partnership/LLC entity itself are generally deductible by the entity on its federal return (Form 1065).
   • Sole Proprietors (Schedule C): Franchise taxes are less common for sole proprietors. If a state imposes a franchise tax or fee on a sole proprietor not based on net income (e.g., a flat business privilege fee or a gross receipts tax), it's generally deductible on Schedule C. However, state taxes based purely on the business's net income are typically treated as the owner's personal state income tax liability, deductible only as an itemized deduction on Schedule A (subject to the $10,000 SALT cap), not on Schedule C.
3. Timing (Accrual vs. Cash): The timing of the deduction follows your business's accounting method. Accrual basis taxpayers generally deduct the tax when the liability becomes fixed and determinable. Cash basis taxpayers deduct when the tax is paid.
4. Recordkeeping: Maintain copies of state franchise tax returns filed, assessment notices received from the state, payment vouchers, and proof of payment (canceled checks, bank/credit card statements).

Examples of Franchise Tax Expenses

Franchise taxes vary significantly by state. Examples include:

• California Franchise Tax: Annual minimum tax for LLCs, S-Corps, C-Corps, plus potential tax based on income for C-Corps.
• Delaware Franchise Tax: Calculated based on authorized shares or assumed par value capital for corporations incorporated in Delaware.
• Texas Margin Tax: A tax based on a business's "margin," often considered a franchise tax.
• New York Franchise Tax: Includes components like a fixed dollar minimum tax and a capital base tax for corporations.
• Other state taxes specifically labeled "Franchise Tax" levied on LLCs, corporations, or partnerships based on net worth, capital, or the privilege of operating.

Tax Implications of Franchise Tax Expenses

Federal Deductibility:

• Franchise taxes levied directly on corporations, S corporations, and partnerships are generally deductible as ordinary and necessary business expenses on the entity's federal tax return.
• For sole proprietors, a state franchise tax or fee is deductible on Schedule C only if it is not based on net income. State taxes based on net income are generally treated as personal income taxes (itemized deduction on Schedule A, subject to the SALT cap).

Timing of Deduction: Deductible when paid (Cash method) or when the liability is fixed (Accrual method).

Where to Report:

• Form 1120, 1120S, 1065: Report on the line designated for "Taxes and licenses."
• Schedule C (Form 1040): If deductible for a sole proprietor (not based on net income), report on Line 23 ("Taxes and licenses").

How Fyle Can Automate Expense Tracking

Tracking state tax payments and related documentation is essential for compliance. Fyle can help manage the process for franchise tax payments:

• Capture Payments: Track franchise tax payments made via company credit card using Fyle's real-time feeds (though ACH or check is more common). Manage payments made via other methods by uploading the state notice/voucher and attaching proof of payment within Fyle.
• Centralize Documentation: Store digital copies of state franchise tax notices, copies of filed returns, payment vouchers, and payment confirmations securely, linked to the payment transaction in Fyle.
• Consistent Categorization: Use Fyle to reliably categorize franchise tax payments under "Taxes and Licenses" or a specific "Franchise Tax Expense" sub-account.
• Track Payment Deadlines: Help manage recurring annual or quarterly franchise tax payment deadlines and amounts.
• Seamless Integration: Fyle syncs categorized expense data to your accounting system (QuickBooks, Xero, NetSuite, Sage Intacct), ensuring accurate financial records for preparing entity or individual tax returns.

State franchise taxes are generally deductible business expenses for the entity they are imposed upon (corporations, partnerships, LLCs), provided they aren't purely net income taxes. For sole proprietors, deductibility on Schedule C depends on whether the tax is based on net income. 

Proper classification, typically under "Taxes and Licenses," and careful recordkeeping are key. Tools like Fyle can assist in organizing the documentation and tracking these state tax payments within your overall expense management workflow.