Corporate Income Taxes

The corporate tax structure, shown in Table 9-7, is relatively simple. To illustrate, if a firm had $65,000 of taxable income, its tax bill would be

= $7,500 + $3,750 = $11,250, and its average tax rate would be $11,250/$65,000 = 17.3%. Note that corporate income above $18,333,333 has an average and marginal tax rate of 35 percent.14

12For assets acquired after December 31, 2000, and held for more than five years, the capital gains rate is 18 percent. This rate is only 8 percent if you are in the 15 percent bracket. The Tax Code governing capital gains is very complex, and we have illustrated only the most common provision.

13Fifty percent of any capital gains on the newly issued stock of certain small companies is excluded from taxation, provided the small-company stock is held for five years or longer. The remaining 50 percent of the gain is taxed at a rate of 20 percent for most taxpayers. Thus, if one bought newly issued stock from a qualifying small company and held it for at least five years, any capital gains would be taxed at a maximum rate of10 percent for most taxpayers. This provision was designed to help small businesses attract equity capital.

14Prior to 1987, many large, profitable corporations such as General Electric and Boeing paid no income taxes. The reasons for this were as follows: (1) expenses, especially depreciation, were defined differently for calculating taxable income than for reporting earnings to stockholders, so some companies reported positive profits to stockholders but losses—hence no taxes—to the Internal Revenue Service; and (2) some companies that did have tax liabilities used various tax credits to offset taxes that would otherwise have been payable. This situation was effectively eliminated in 1987.

The principal method used to eliminate this situation is the Alternative Minimum Tax (AMT). Under the AMT, both corporate and individual taxpayers must figure their taxes in two ways, the "regular" way and the AMT way, and then pay the higher of the two. The AMT is calculated as follows: (1) Figure your regular taxes. (2) Take your taxable income under the regular method and then add back certain items, especially income on certain municipal bonds, depreciation in excess of straight line depreciation, certain research and drilling costs, itemized or standard deductions (for individuals), and a number of other items. (3) The income determined in (2) is defined as AMT income, and it must then be multiplied by the AMT tax rate to determine the tax due under the AMT system. An individual or corporation must then pay the higher of the regular tax or the AMT tax. In 2001, there were two AMT tax rates for individuals (26 percent and 28 percent, depending on the level of AMT income and filing status). Most corporations have an AMT of 20 percent. However, there is no AMT for very small companies, defined as those that have had average sales of less than $7.5 million for the last three years.

TABLE 9-7 Corporate Tax Rates as of January 2001

If a Corporation's Taxable Income Is

It Pays This Amount on the Base of the Bracket

Plus This Percentage on the Excess over the Base

Average Tax Rate at Top of Bracket

Up to $50,000

$0

15%

15.0%

$50,000-$75,000

7,500

25

18.3

$75,000-$100,000

13,750

34

22.3

$100,000-$335,000

22,250

39

34.0

$335,000-$10,000,000

113,900

34

34.0

$10,000,000-$15,000,000

3,400,000

35

34.3

$15,000,000-$18,333,333

5,150,000

38

35.0

Over $18,333,333

6,416,667

35

35.0

See Ch 09 Tool Kit.xls for details.

Interest and Dividend Income Received by a Corporation Interest income received by a corporation is taxed as ordinary income at regular corporate tax rates.

However, 70 percent of the dividends received by one corporation from another is excluded from taxable income, while the remaining 30 percent is taxed at the ordinary tax rate.15 Thus, a corporation earning more than $18,333,333 and paying a 35 percent marginal tax rate would pay only (0.30)(0.35) = 0.105 = 10.5% of its dividend income as taxes, so its effective tax rate on dividends received would be 10.5 percent. If this firm had $10,000 in pre-tax dividend income, its after-tax dividend income would be $8,950:

After-tax income

Before-tax income — Taxes

= Before-tax income — (Before-tax income)(Effective tax rate) = Before-tax income(1 — Effective tax rate) = $10,000[1 — (0.30)(0.35)] = $10,000(1 — 0.105) = $10,000(0.895) = $8,950.

If the corporation pays its own after-tax income out to its stockholders as dividends, the income is ultimately subjected to triple taxation: (1) the original corporation is first taxed, (2) the second corporation is then taxed on the dividends it received, and (3) the individuals who receive the final dividends are taxed again. This is the reason for the 70 percent exclusion on intercorporate dividends.

If a corporation has surplus funds that can be invested in marketable securities, the tax factor favors investment in stocks, which pay dividends, rather than in bonds, which pay interest. For example, suppose GE had $100,000 to invest, and it could buy either bonds that paid interest of $8,000 per year or preferred stock that paid dividends of $7,000. GE is in the 35 percent tax bracket; therefore, its tax on the interest, if it bought bonds, would be 0.35($8,000) = $2,800, and its after-tax income would be $5,200. If it bought preferred (or common) stock, its tax would be 0.35[(0.30)($7,000)] = $735, and

15The size of the dividend exclusion actually depends on the degree of ownership. Corporations that own less than 20 percent of the stock of the dividend-paying company can exclude 70 percent of the dividends received; firms that own more than 20 percent but less than 80 percent can exclude 80 percent of the dividends; and firms that own more than 80 percent can exclude the entire dividend payment. We will, in general, assume a 70 percent dividend exclusion.

TABLE 9-8 Returns to Investors under Bond and Stock Financing

Use Bonds

Use Stock

See Ch 09 Tool Kit.xls for details.

Taxable income Federal-plus-state taxes (40%) After-tax income Income to investors Rate of return on $10 million of assets

Sales

Operating costs

Earnings before interest and taxes (EBIT) Interest

$1,500,000 600,000

its after-tax income would be $6,265. Other factors might lead GE to invest in bonds, but the tax factor certainly favors stock investments when the investor is a corporation.16

Interest and Dividends Paid by a Corporation A firm's operations can be financed with either debt or equity capital. If it uses debt, it must pay interest on this debt, whereas if it uses equity, it is expected to pay dividends to the equity investors (stockholders). The interest paid by a corporation is deducted from its operating income to obtain its taxable income, but dividends paid are not deductible. Therefore, a firm needs $1 of pre-tax income to pay $1 of interest, but if it is in the 40 percent federal-plus-state tax bracket, it must earn $1.67 of pre-tax income to pay $1 of dividends:

Working backward, if a company has $1.67 in pre-tax income, it must pay $0.67 in taxes [(0.4)($1.67) _ $0.67]. This leaves it with after-tax income of $1.00.

Table 9-8 shows the situation for a firm with $10 million of assets, sales of $5 million, and $1.5 million of earnings before interest and taxes (EBIT). As shown in Column 1, if the firm were financed entirely by bonds, and if it made interest payments of $1.5 million, its taxable income would be zero, taxes would be zero, and its investors would receive the entire $1.5 million. (The term investors includes both stockholders and bondholders.) However, as shown in Column 2, if the firm had no debt and was therefore financed only by stock, all of the $1.5 million of EBIT would be taxable income to the corporation, the tax would be $1,500,000(0.40) _ $600,000, and investors would receive only $0.9 million versus $1.5 million under debt financing. The rate of return to investors on their $10 million investment is therefore much higher if debt is used.

16This illustration demonstrates why corporations favor investing in lower-yielding preferred stocks over higher-yielding bonds. When tax consequences are considered, the yield on the preferred stock, [1 — 0.35(0.30)](7.0%) _ 6.265%, is higher than the yield on the bond, (1 — 0.35)(8.0%) _ 5.200%. Also, note that corporations are restricted in their use of borrowed funds to purchase other firms' preferred or common stocks. Without such restrictions, firms could engage in tax arbitrage, whereby the interest on borrowed funds reduces taxable income on a dollar-for-dollar basis, but taxable income is increased by only $0.30 per dollar of dividend income. Thus, current tax laws reduce the 70 percent dividend exclusion in proportion to the amount of borrowed funds used to purchase the stock.

Pre-tax income needed $1 $1

Of course, it is generally not possible to finance exclusively with debt capital, and the risk of doing so would offset the benefits of the higher expected income. Still, the fact that interest is a deductible expense has a profound effect on the way businesses are financed—our corporate tax system favors debt financing over equity financing. This point is discussed in more detail in Chapters 6 and 13.

Corporate Capital Gains Before 1987, corporate long-term capital gains were taxed at lower rates than corporate ordinary income, so the situation was similar for corporations and individuals. Under current law, however, corporations' capital gains are taxed at the same rates as their operating income.

Corporate Loss Carry-Back and Carry-Forward Ordinary corporate operating losses can be carried back (carry-back) to each of the preceding 2 years and forward (carry-forward) for the next 20 years and used to offset taxable income in those years. For example, an operating loss in 2003 could be carried back and used to reduce taxable income in 2001 and 2002, and forward, if necessary, and used in 2004, 2005, and so on, to the year 2023. The loss is typically applied first to the earliest year, then to the next earliest year, and so on, until losses have been used up or the 20-year carryforward limit has been reached.

To illustrate, suppose Apex Corporation had $2 million of pre-tax profits (taxable income) in 2001 and 2002, and then, in 2003, Apex lost $12 million. Also, assume that Apex's federal-plus-state tax rate is 40 percent. As shown in Table 9-9, the company would use the carry-back feature to recompute its taxes for 2001, using $2 million of the 2003 operating losses to reduce the 2001 pre-tax profit to zero. This would permit it to recover the taxes paid in 2001. Therefore, in 2003 Apex would receive a refund of its 2001 taxes because of the loss experienced in 2003. Because $10 million of the unrecovered losses would still be available, Apex would repeat this procedure for 2002. Thus, in 2003 the company would pay zero taxes for 2003 and also would receive a refund for taxes paid in 2001 and 2002. Apex would still have $8 million of unrecovered losses to carry forward, subject to the 20-year limit. This $8 million could be used to offset taxable income. The purpose of this loss treatment is to avoid penalizing corporations whose incomes fluctuate substantially from year to year.

Improper Accumulation to Avoid Payment of Dividends Corporations could refrain from paying dividends and thus permit their stockholders to avoid personal income taxes on dividends. To prevent this, the Tax Code contains an improper

See Ch 09 Tool Kit.xls for details.

TABLE 9-9 Apex Corporation: Calculation of Loss Carry-Back and CarryForward for 2001-2002 Using a $12 Million 2003 Loss

2001

2002

Original taxable income

$2,000,000

$

2,000,000

Carry-back credit -

- 2,000,000

-

2,000,000

Adjusted profit

$0

$

0

Taxes previously paid (40%)

800,000

800,000

Difference = Tax refund

$ 800,000

$

800,000

Total refund check received in 2003: $800,000 + $800,000 =

$1,600,000

Amount of loss carry-forward available for use in 2004-2023:

2003 loss

$12,000,000

Carry-back losses used

4,000,000

Carry-forward losses still available

$

8,000,000

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