- Two interesting corporate income tax issues
are first corporate income is double taxed,
first, corporate income is double taxed,
and second interest is deductible as a business expense
for a corporation.
Let's discuss each one of these issues.
So, corporate income is subject to double taxation.
Let me illustrate with a numerical example.
Miles Company, a corporation,
has income before any income taxes of 10 million dollars.
In this simple example,
the income tax rate is 40% on all income.
on all income.
Miles Company, the corporation,
has to pay income tax at the corporate level.
$10 million times the 40% tax rate means
10 million dollars times the 40% tax rate,
means that the corporate income tax
that the corporateincome tax is $4 million.
is four million dollars.
That corporate income tax
That corporate income tax is given
is given to the Government Taxing Authority,
to the government taxing authority,
leaving six million dollars
leaving $6 million thatbelongs to the shareholders
that belongs to the shareholders of Miles Company.
of Miles Company.
If all of the remaining profit is paid out as dividends,
If all of the remaining profitis paid out as dividends,
the six million dollars is then going to be taxed again
at the individual shareholder level.
If we assume that dividends are taxed at the same rate,
If we assume that dividendsare taxed at the same rate,
that's another 40% of the six million dollars.
That's another 2.4 million dollars in tax
that has to be paid.
Total tax paid on this 10 million dollars of income
for Miles Company, the corporation,
is 6.4 million dollars.
$4 million by the corporation
Four million by the corporation
and 2.4 million by the individual shareholders.
and $2.4 million by theindividual shareholders.
That is 6.4 million dollars in total income tax
on just 10 million dollars of income.
of income.
That's a 64% effective tax rate,
when the highest tax rate in this simple example is 40%.
when the highest tax rate inthis simple example is 40%.
Now is this double taxation of corporate income fair
Now, is this double taxationof corporate income fair
or not fair?
Well on the not fair side, some would say,
Well, on the not fairside, some would say,
hey a 64% effective rate
when the highest tax rate is 40% seems unfair.
seems unfair.
Also, because a corporation
is just a collection of individual owners,
of individual owners, why should they have
why should they have to pay tax on their income twice.
to pay tax on their income twice?
Now those are the arguments on the not fair side.
On the fair side,
the second taxing doesn't happen
until the income is paid out in the form of dividends.
If the income is never paid out in the form of dividends,
but is instead piled back into the business for expansion,
that second taxing never happens.
In fact, if the profits are put back in the business,
the business increases in value.
If a shareholder then sales his or her shares,
If a shareholder thensells her or his shares,
that increase in value is a capital gain
and would be taxed at low, favorable,
long-term capital gains rates.
So the argument on the fair side,
is that corporate shareholders
that corporate shareholderscan avoid the double taxation
can avoid the double taxation
just by having corporate profits retained
just by having corporateprofits retained in the business
in the business for expansion.
for expansion.
Another argument on the fair side,
is that people who own shares in corporations
who own shares incorporations, on average,
on average have more money
have more money than peoplewho do not own shares
than people who do not own shares in corporations.
in corporations.
They are higher income individuals,
thus, this double taxation of corporate income
thus, this double taxation ofcorporate income can be viewed
can be viewed as just another manifestation
as just another manifestationof a progressive tax system
of a progressive tax system.
In which higher income individuals,
pay higher income tax rates.
income tax rates.
Now is corporate double taxation fair or not fair,
well I don't know, you can decide.
But those are the arguments on both sides.
Another interesting income tax issue
with respect to corporations,
is the fact that interest is a tax deductible expense.
that interest is a tax deductible expense.
Now interest is a tax deductible expense for all businesses,
for all businesses, sole proprietorships,
sole proprietorships, partnerships, and corporations.
partnerships, and corporations,
But this tax deductibility,
but this tax deductibilityhas interesting applications
has interesting applications with corporations.
with corporations.
Governments around the world allow companies
to deduct interest as a tax deductible expense.
But dividends paid by corporations,
are not allowed as a tax deductible expense.
as a tax deductible expense.
Therefore, when a company raises new capital for expansion,
if the company chooses to borrow money
and then pay interest on that money,
that interest expense is a tax deductible expense.
In contrast, if the company decides to raise capital
by getting money from shareholders and then pays dividends
and then pays dividendsto those shareholders,
to those shareholders,
those dividend payments are not a tax deductible expense.
What that means is that,
because interest expense is tax deductible,
the tax codes around the world encourage corporations
to borrow money rather than
to get additional shareholder investment as they expand.
shareholder investment as they expand.