{"id":3695,"date":"2023-04-19T14:55:07","date_gmt":"2023-04-19T19:55:07","guid":{"rendered":"https:\/\/illinoistax.org\/?p=3695"},"modified":"2023-04-20T10:43:51","modified_gmt":"2023-04-20T15:43:51","slug":"tax-facts-an-illinois-chartbook-how-does-illinois-compare-2","status":"publish","type":"post","link":"http:\/\/illinoistax.org\/?p=3695","title":{"rendered":"Illinois’ Franchise Tax: An Archaic Outlier"},"content":{"rendered":"

Illinois’ Franchise Tax: An Archaic Outlier<\/u><\/strong><\/h3>\n

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April 2023 (76.3)<\/strong><\/p>\n

The Taxpayers\u2019 Federation of Illinois has long been an advocate of repealing Illinois\u2019\u00a0antiquated and archaic franchise tax.\u00a0 In June of 2019, with much fanfare, Governor Pritzker signed S.B. 689 (P.A. 101-9), phasing out the tax.\u00a0 Unfortunately, in the early days of the\u00a0COVID-19 pandemic, when concerns for state finances were high, the phase-out was halted, leaving the tax and its cumbersome compliance requirements in place.\u00a0 This article\u00a0summarizes the history, outlier status, and administrative complications of the Illinois\u00a0franchise tax.<\/p>\n

What is the franchise tax?
\n<\/b>The term \u201cfranchise tax\u201d can cover a wide variety of tax structures but is usually a tax on\u00a0corporations separate from the income tax. A few states, like California, use the label for their corporate income tax, but it is typically a tax based on some measure of net worth or capital value.\u00a0 The Illinois franchise tax was enacted in 1872.<\/p>\n

The Secretary of State registers and regulates corporations and other business entities and charges an assortment of fees to do so.\u00a0 It also administers and collects the franchise tax.\u00a0Although revenues from the fees are frequently lumped together with those from the true franchise tax, our focus is only on the tax itself, and not on the activity-based fees.<\/p>\n

Illinois\u2019 franchise tax is actually three separate taxes, all based on paid-in capital. \u201cPaid-in\u00a0capital\u201d is, generally, the money investors pay in return for their shares of stock.\u00a0 It can be funds raised when a corporation issues stock, or through additions to capital (usually\u00a0subsequent investments by new or existing shareholders), and it can go down when certain corporate transactions occur.\u00a0 Paid-in capital is neither revenue nor net worth; it is the money used to build a business.<\/p>\n

When a corporation first registers with the Illinois Secretary of State it pays the first of the three franchise tax components: an \u201cinitial tax\u201d on its paid-in capital in the state, at a rate of 0.10%. Each year thereafter, a corporation pays an \u201cannual tax\u201d at the same rate (0.10%).\u00a0Finally, there is an \u201cadditional tax\u201d on increases to paid-in capital, at a rate of 0.15%. The\u00a0annual and initial taxes have a minimum of $25 and a maximum of $2 million, but the\u00a0additional tax has no cap. 1<\/sup> The 2019 legislation phased out all three components of the tax over four years, completely eliminating the franchise tax in 2024, but in 2021 the repeal was repealed.<\/p>\n

The 2021 legislation retained the first steps of the franchise tax phase-out.\u00a0 For each of the three franchise taxes (initial, annual, and additional), the first $1,000 in tax due is exempted from tax.\u00a0 As a result, all corporations incorporated or doing business in Illinois must still\u00a0calculate and file their tax returns, but in many cases, no tax is due.<\/p>\n

How big is the franchise tax?
\n<\/b>The three components of the franchise tax raised $170 million in fiscal year 2022, about 0.34% of general fund revenues (down from 0.41% two years earlier). \u00a0The corporate income tax raised $5.4 billion.\u00a0\u00a0 Table 1 shows the number of filers and total revenue generated by the various components of the franchise tax during the fiscal year ended June 30, 2022.<\/p>\n

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All corporations face the burden of calculating their franchise taxes, no matter their size, but as stated above, the first $1,000 in tax liability is exempt, so many filers end up paying no tax.\u00a0 For example, of the 342,022 corporations required to file an annual report in fiscal year 2022, only 40,502 of them owed annual franchise tax that year.\u00a0 Even so, each of the filers had to first determine whether any tax was due.\u00a0\u00a0 And, as discussed in further detail below,\u00a0calculating Illinois\u2019 franchise tax is not a straightforward process.<\/p>\n

The franchise tax is a flawed tax.
\n<\/b>The five-year economic development plan released by Governor Pritzker in October 2019\u00a0contained eight variations of the following statement, a clear recognition that the Illinois\u00a0franchise tax is flawed and its repeal was (and should be again) a noteworthy\u00a0accomplishment:<\/p>\n

The governor worked with the General Assembly to eliminate the Corporate\u00a0<\/i>Franchise Tax, which posed a significantly high compliance burden and penalized businesses for locating or expanding their operations in the state.<\/i><\/p>\n

The first problem with Illinois\u2019 franchise tax is one shared by all taxes in this category:\u00a0 taxes on net worth, capital stock, or paid-in capital result in pyramiding.\u00a0 In other words, a single\u00a0investment may be taxed multiple times.\u00a0 It is not unusual for businesses to operate using\u00a0several legal entities under a parent corporation.\u00a0 This can be for any number of reasons\u2014regulatory requirements, accommodating new investors, or simply a legacy of business\u00a0expansion.\u00a0 This very common structure frequently leads to a disproportionate franchise tax liability.\u00a0 For example, assume two investors form Company A with $10,000.\u00a0 After a few years Company A expands into a slightly different business, so it forms a new subsidiary, Company B, investing\u00a0$10,000.\u00a0 A few years later, Company B purchases 90% of the stock of a new\u00a0venture in the same line of business\u2014Company C\u2014for $10,000.\u00a0 Each year thereafter, that original $10,000 investment is taxed under Illinois\u2019 annual franchise tax 3 times because it is part of the paid-in capital of Companies A, B, and C.\u00a0If Company A had merely sat on that\u00a0original investment, or had expanded within the existing corporation, that $10,000 would be taxed only once.<\/p>\n

A \u201cgood\u201d tax is one that does not pick winners and losers based on artificial differences.\u00a0 The pyramiding problem described above is one way the franchise tax fails this test.\u00a0 Another\u00a0occurs when debt is used, rather than equity. A corporation financed with more debt, and lower owners\u2019 investments, has lower paid-in capital and thus lower franchise tax liability,\u00a0resulting in two otherwise identical businesses paying very different amounts of tax.\u00a0 For\u00a0example, if the owners of Corporation X take out $1,000,000 in personal loans and then invest the funds in the Corporation, its paid-in capital will be $1,000,000.\u00a0 Conversely, if the owners of Corporation Y invest $10 in the Corporation, but it borrows $1,000,000 (guaranteed by the owners), it will have the same $1,000,000 to operate its business as Corporation X, but will face a much smaller franchise tax liability.<\/p>\n

Using paid-in capital as a proxy for the benefit (or value) owners receive from incorporation, which was the original justification for Illinois\u2019 franchise tax, makes little sense. Owners are protected from the corporation\u2019s liabilities, but amounts invested are at risk. The more a\u00a0corporation\u2019s owners have paid in, and therefore the more paid-in capital it has, the more the owners stand to lose. All else being equal, the value to owners of a business\u2019s operating as a corporation decreases <\/i>as paid-in capital increases. Franchise tax liability, however, increases.<\/p>\n

Illinois\u2019 franchise tax has its own unique quirks, making it an outlier even among the few states still imposing this kind of tax, and adding to its policy and practical failings.\u00a0 As\u00a0discussed in more detail below, Illinois does not use net worth or any standard measure of corporate value as its tax base; Illinois taxpayers must instead track and maintain separate\u00a0calculations solely for the purpose of paying this tax.\u00a0\u00a0 Likewise, the apportionment method used for multistate corporations to determine what portion of their tax base (paid-in capital) is taxable by Illinois is different from that used for Illinois\u2019 income tax, and from any\u00a0apportionment method used for any other state\u2019s tax, needlessly increasing the\u00a0administrative burden associated with complying with this tax. And finally, Illinois\u2019 franchise tax is administered by the Secretary of State rather than the Department of Revenue, which means separate filings, separate due dates, and a separate administrative regime.<\/p>\n

What do other states do?
\n<\/b>Franchise taxes are rare.\u00a0 While most states charge corporations an annual fee to operate in their state, and nearly every state taxes a corporation\u2019s profits under its corporate income tax, Illinois is one of only a few states to tax corporations based on a measure of their net worth, capital stock, or paid-in capital.<\/p>\n

The map below shows the sixteen states that currently impose what can broadly be called franchise taxes. Kansas, Missouri, Ohio, Pennsylvania, Rhode Island, and West Virginia have all repealed similar taxes in recent years.\u00a0 Of the sixteen:<\/p>\n