Heart-Attack Tax Season for Delaware Startups
It’s that time of year again: Tax season. In addition to the headache of personal income taxes, entrepreneurs have to deal with business taxes. Around this time each year, as sure as the sunrise, I get calls and messages from irate founders of new startups who received franchise tax bills from the State of Delaware for an insane amount like $75,000. Why on earth would startup lawyers like me recommend that new companies incorporate in Delaware if they’re going to get fleeced by the tax collector?
The answer lies in the formulas used to calculate franchise tax, but first, let’s take a step back. The first questions I’m usually asked by founders include whether they should incorporate in the state where they’re headquartered (usually California in the case of my clients) or in another state such as Delaware, and how many shares of stock to authorize and issue to give effect to the equity structure they’ve agreed upon with co-founders (usually expressed in percentages). The two issues are linked to the extent that some states calculate tax based on the number of outstanding shares.
Nevertheless, I usually advise new startups to incorporate in Delaware and authorize 10 million shares to start, both of which are industry standard terms in Silicon Valley. Here’s why:
Delaware offers two alternative methods of calculating franchise tax payable by a corporation domiciled there. (“Franchise” in this context refers not to your local McDonald’s restaurant, but rather to the right of a corporation or other entity to transact business in a given state.) Keeping in mind that Delaware is home to many of the largest corporations in the world, the “Authorized Shares Method” uses a formula that amounts to $150 + $75 for every 10,000 shares beyond the first 10,000. When the state sends out franchise tax invoices each winter, it calculates and states the amount of tax payable based on this method. So our hypothetical 10-million-share startup would get a franchise tax bill for more than $75,000. Ouch.
The alternative method, called the “Assumed Par Value Capital Method,” is more proportionate to a corporation’s actual size. Forget about the confusing terminology for a moment and focus on the formula: $350 tax for each $1 million of “assumed par value capital.” Sounding better already? A seed-stage startup is likely to have less than that amount, calculated as follows:
Total Gross Assets
Assumed Par Value Cap = ——————- X Authorized Shares
This calculation essentially takes the corporation’s gross assets and the current number of issued shares and extrapolates based on an assumption that the remainder of the authorized shares will be issued. Note that assumed par value only applies if it is less than the real par value for any given class of stock as defined in the Certificate of Incorporation. (This explains why most startups at the time of incorporation set a very low par value, such as $0.001 per share, for their Common Stock.) For a bootstrapped, friends-and-family or angel-funded early stage startup, gross assets are likely to amount to only six figures. Regardless, Delaware places a floor of $350 under this method.
If you think a $350 tax bill beats one for $75,000, you’re not alone. If you’re wondering why the state would choose the authorized shares method when sending out annual franchise tax bills, I invite you to draw your own conclusions.
Finally, the assumed par value capital method explains why it makes no practical difference for a new startup to authorize and issue 10 million shares versus 1 million or 100,000 in Delaware. Given a nominal par value for the class of stock, what really matters under that formula is the amount of total gross assets and the ratio of issued to unissued shares. Try running the numbers and it becomes clear that any company with less than $2 million assumed par value capital will pay less tax under this method vs. the authorized shares method even if it has authorized only 100,000 shares.
Please note that every taxpayer’s situation is unique. Consult your tax advisor for personalized advice. This article is for general informational purposes only; it does not result in the creation of an attorney-client relationship. All opinions expressed are those of the author and do not necessarily represent those of Gust.
Written by Antone Johnson
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