Texas is becoming the hot new thing when it comes to incorporating your company because of the tax incentives the state offers. However, if you’re a startup there are a couple reasons why incorporating in Texas may not be such a good idea:
- The Texas Franchise Tax
- Investors, especially VCs, prefer Delaware Corporations
Why Texas's Franchise Tax Can Be Costly For Startups
Although it may seem advantageous to incorporate in Texas because of tax breaks and low annual fees, the Texas franchise tax can be detrimental to a startup. The Texas franchise tax is functionally a gross receipts tax because the tax is calculated based on a company’s income as a result of sales. Specifically, you pay a percentage on the lowest of the following calculations for your franchise tax payment:
- Total revenue times 70 percent;
- Total revenue minus cost of goods sold (COGS);
- Total revenue minus compensation; or
- Total revenue minus $1 million
This means that the franchise tax does not take into account business costs of production. Startup companies are particularly strained by this tax structure because they typically post losses in their early years.
If any of the calculations comes out to $1.23 million or less, then you will not have to pay the franchise tax. However, $1.23 million is an extremely low threshold and it is difficult to stay under this threshold to avoid paying your Texas franchise tax. Therefore, it is likely that you will have to pay this tax in Texas. Even if you are taxed at the lowest bracket, you are still responsible for paying more than $400.
On the other hand, Delaware has a corporate income tax which considers business production costs when calculating your corporate income tax payment.This means that business production costs are deducted when calculating how much taxes you owe to Delaware. Business production costs include things such as:
- Business loans
- All ordinary and necessary business expenditures
- Expenses for bookkeeping, legal charges, advertising, and travel
- Employee expenses such as salary, health insurance, bonus, and even tuition reimbursements
- Insurance premiums, interest payments, bad debts, fuel tax, excise tax
These deductions are particularly helpful for startups because it is a better representation of the losses startup companies incur in their early years. This also means that in Delaware, your company is being taxed on its actual income as opposed to how much income the state thinks you made.
Admittedly, the Texas franchise rate is lower compared to the Delaware corporate income tax rate. However, the base number used to calculate the Texas franchise tax is much higher than the base number used to calculate the Delaware corporate income tax. Therefore, it is very likely that you will end up paying less in your Delaware corporate income tax than your Texas franchise tax.
Delaware also has a franchise tax that is calculated through different means from the Texas franchise tax. However, if you are responsible for paying the Texas franchise tax, your minimum payment will be higher than any Delaware franchise tax minimum payments.
The bottom line: it is highly likely that your combined Delaware franchise tax and corporate income tax will be lower than your Texas franchise tax payment.
Investors Still Prefer Delaware Corporations
Investors, especially VCs, prefer Delaware corporations largely in part of Delaware’s well-established, business friendly statutory and case law. The well-established laws mean that Delaware’s business governance practice and contract interpretation has the least ambiguities out of any other state. Because of this, any serious corporate lawyer is well-versed in Delaware corporate law. This means that any legal questions you or your investor may have over your company can likely be easily answered.
By contrast, if you incorporate your company in Texas, there is likely to be ambiguities in the state’s business governance practice and contract interpretation. This means that lawyers will likely have to do research before they can answer any questions you or your investor may have. Since the lawyer will have to do research, you or your investor will probably have to pay them for the time they spend researching, and no one wants to pay for legal professionals if they don’t have to.
The strong business friendly laws in Delaware means the courts typically defer to the business judgements of a corporation’s directors and officers unless there is evidence of gross self-dealing or negligence. Not only do these laws make it easier for you to run your company, but it also puts investors at ease when they invest in your company. Your investors will know that, barring something catastrophic, the state will not interfere with your business practices which makes their investment more predictable and safe.
(Want to learn more about why companies choose Delaware? Check out Why Do Startups Incorporate In Delaware? on the Capbase Blog.)
Other Reasons To Make Delaware Your Incorporation Destination
Although Texas holds itself out to be a business-friendly state, Texas simply does not have the case law history to resolve the ambiguities that will inevitably arise in business governance practices and contract interpretation. Whereas Delaware, has an entire court dedicated to resolving business disputes. On top of well-established case law, any potential disputes that arise involving your Delaware corporation can be resolved quickly through this special court.
Another benefit of having a specialized court for business disputes is that the judges hearing your dispute have expertise in business and corporation law. This means that not only are you receiving expert opinion on your dispute, but also the outcome of the dispute is more predictable and you can prepare as such.
If you plan on fundraising from VC’s then it is in your best interest to incorporate your startup in Delaware. VCs have such a preference for Delaware corporations that they will refuse to invest in corporations that are not incorporated in the state.
If you are ready to incorporate your company in Delaware, Capbase can help! When you incorporate your Delaware corporation on Capbase, we will generate the required information needed to make sure your incorporation goes smoothly.
The compliance calendar inside your Capbase account will notify you of upcoming fees, reporting, or other requirements, so you can keep your startup in good standing with Delaware state officials.
Written by Beth Zhao
Beth is a second year law student at The George Washington Law School. She is a member of the Public Contract Law Journal.
Startups from Brazil, Chile, Mexico, Colombia, and other Latin American countries can access opportunities in the US by registering a business here. This guide covers corporate structure, incorporation, fees, taxes, and more.
A brief but comprehensive overview of startup taxes and compliance.