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| US Federal Tax Brackets |
Corporate Income Taxes
The corporate income tax system is complicated. As below table 01 shows, the federal tax rate generally increases with the level of income. The tax rate applied to the last dollar of income is called the marginal tax rate. The average tax rate is the total taxes paid divided by taxable income. A progressive tax system has an average tax rate that increases for some increases in the level of income but never decreases with such increases. The marginal tax rate is greater than the average tax rate in a progressive tax system.
As income is taxed at the higher marginal tax rate in a progressive tax system, the average tax rate continues to increase toward the marginal tax rate. In graph no. 01 shows the relationship between the marginal and average tax rates at various levels of taxable corporate income for the tax structure shown in table no. 01. In the first range, indicated by an A (where taxable income is between zero and $50,000), the average and marginal rates are both 15%. In range B, the marginal tax rate is 25% and the average tax rate increases over the range to 18.3%. In range C, the marginal rate is 34% and the average rate increases over the range to 22.3%. Because of the lower rate on the "earlier" income, the average tax rate will never become equal to the marginal rate.
To equalize the two rates, Congress set the marginal rate at 39% on income over $100,000 until the average rate increases to 34%. At a taxable income of $335,000, the average and marginal rates are both equal to 34%. For taxable incomes between $335,000 and $10 million, the marginal rate is set back to 34%. For taxable incomes between $10 and $15 million, the marginal tax rate is increased again, to 35%. Once again to raise the average tax rate to this higher marginal rate, the marginal rate is 35% for taxable incomes between $14 and $18.33 million. Above $18.33 million, all incomes are taxed at both a marginal and an average rate of 35%.
There are two more important complications. First, tax structures are often modified. Thus the average and marginal tax rates that apply to a corporation can and do change from
Table No. 01
Table No. 01
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| us federal tax brackets |
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| Marginal and average corporate income tax rates |
We'll simply specify an income tax rate, such as 40%. We intend whatever rate we specify to reflect all taxes from all levels. The single rate is a simplified approximation of taxes. We use different tax rates to emphasize that actual tax rates vary over time and from one location to another.
Corporate Capital Gains
A long term capital gain or loss, referred to simply as a capital gain, occurs for tax purposes when an asset that has been owned for a sufficiently long time (currently, at least one year) is sold for more or less than its tax basis (that is, its net book value for tax purposes). Although an actual gain or loss occurs every time the market value of the asset changes, the gain or loss is not recognized for tax purposes until the asset is sold. This means that the tax on the gain is postponed indefinitely until the asset is sold. Of course, this also means no tax reducing losses can be claimed until the asset is sold. This is an important complicating feature of the tax system. It creates what is called a tax timing option. We will describe and discuss tax timing options in more detail later.
Corporate capital gains are currently taxed at the same rates as regular income. Before 1987 corporate capital gains were taxed at a lower rate. A lower tax rate on capital gains provides extra incentive to invest in capital assets. Short term capital gains (or losses) that result from holding assets for less than the required year are taxed as regular income.
Tax Treatment of Interest Expense and Dividends Paid
Interest paid on debt obligations is a tax deductible expense. Dividends paid to common and preferred stockholders are not. If a company is to pay $100 of interest, the company needs $100 of earnings before interest and taxes (EBIT). However, if a company is to pay $100 of dividends, it will need more than $100 of EBIT, because taxes will be deducted from EBIT.
In the first case the $100 of interest is a tax deductible expense, so no taxes will be due on the $100 of EBIT. However, in the second case, the $100 of dividends is not a deductible expense, so taxes are due on the $100 before dividends are paid. Suppose the tax rate is 40%. Taxes of $40 will be paid out of the $100 of EBIT. This will leave only $60 to pay the planned $100 of dividends.
To find the amount of EBIT necessary to cover the dividends, simply divide the dividend amount by 1 minus the marginal tax rate. If the marginal tax rate is 40%.
EBIT needed = 100/(1 - 0.40) = 100/0.6 = $166.67
If EBIT is $166.67, taxes due on this will be $66.67 (=[0.40]166.67). This will leave $100 (=166.67-66.67) after taxes to pay the dividend.
This unequal or asymmetric, treatment of interest expense and dividend payments effectively lowers the tax bills of corporations that use more debt financing. Conversely, it increases the tax bills of corporations that use more equity financing.
Intercorporate Dividend Exclusion
At least 70% of dividends received by a corporation from another corporation are not taxed. The remaining dividends received are taxed at ordinary rates.
The reason for an intercorporate dividend exclusion involves the concept of multiple taxation. In the U.S. tax system, income is taxed once at the corporate level when the company earns the income and it is taxed a second time at the personal level when dividends are paid to individual shareholders. This results in what is called double taxation. Fully taxing intercorporate dividends would amount to triple taxation. To reduce the impact of this, a substantial part of intercorporate dividends, currently 70%, is effectively excluded from taxation.
Incidentally, interest received by one corporation from another is fully taxable. There are situations wherein a corporation might prefer to purchase preferred stock (over a debt instrument) because an intercorporate dividend exclusion results in lower taxes and a higher after tax return on the investment.
Improper Accumulations of Income to Avoid Payment of Taxes
If a corporation does not pay a dividend, its shareholders do not receive the dividend income and do not incur a personal tax liability. The U.S. tax code imposes a substantial penalty on a corporation if it accumulates earnings for the purpose of enabling its shareholders to avoid the payments of personal income taxes. A corporation is allowed to accumulate $250,000 of retained earnings without being subject to this tax. Accumulations above $250,000 are subject to the penalty tax if they are considered unnecessary for the reasonable needs of the business. However, if these funds are reinvested in the company to buy more assets, to pay off debt obligations, or to provide a reasonable amount of liquidity, the improper accumulations tax is not imposed. Although this penalty tax is very rarely imposed, the threat of the penalty is real. It encourages corporations either to use the funds in the company or to distribute them as dividends.
Tax Loss Carry Backs and Carry Forwards
If a corporation shows a loss (has a negative net income), this loss can be "carried back" as much as three years or "carried forward" for as much as 15 years to offset taxable income in those years. For example, suppose a corporation has negative net income this year but had positive net income and paid taxes within the last three years. This year's loss can be used to offset previous profits (carried back), and the government will refund some previously paid taxes. If the corporation's current loss exceeds its previous income, the company can use the loss to offset future profits (carry the loss forward) and reduce its future taxes.
S Corporations
The so called Subchapter S regulation permits small businesses that meet certain requirements to choose to be taxed as partnerships or proprietorships instead of as corporations. This allows the corporation to receive some of the benefits of the corporate form of organization and yet avoid the double taxation of income. Subchapter S corporate income is reported as personal income by its owners. The individual owners then pay personal income taxes on the part of the income that is allocated to each of them.
Personal Income Taxes
Personal income taxes are the federal government's largest source of income. In a recent year, they made up 36% of its total income. Here we'll look at some of the features of the personal income tax system that have implications for financial management.
Personal Income Tax Rates
Like corporate income tax rates, personal income tax rates increase with income, going from zero to a maximum of 39.6%. The marginal tax rates for the two most common filing status categories ("single" and "married, filing jointly") are shown in table no. 02. There are other schedules for people classified as "married, filing separately" or as "head of household". Personal tax rates are further complicated by the elimination of certain exemptions and deductions for higher incomes. The elimination of an exemption or deduction raises the effective tax rate. In addition, individuals pay social security and Medicare taxes and income taxes to state and local governments, so the effective tax rates for individuals can be much higher than the rates in table no. 02
Table No. 02
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| us federal tax brackets |
Exemptions and Deductions
Taxable income is equal to gross income minus allowable exemptions and deductions. For each dependent there is an exemption, which was $2650 in 1997 and increases each year with inflation. In addition, you can chose either to itemize deductions include such things as home mortgage interest, gifts to charity, state and local income taxes paid, real estate taxes paid and some medical and job related expenses. As mentioned above, some exemptions and deductions are eliminated for incomes above certain levels.
Dividend and Interest Income
Dividend income received from common stock and preferred stock is fully taxable. Income from interest paid by corporations, financial institutions and individuals is also fully taxable. However, recall from our discussion of the Principle of Two Sided Transactions that interest on munis (municipals), certain state and local government bonds, is not taxable by the federal government. Consequently, munis can be attractive investments. However, their relative attractiveness depends on one's marginal income tax rate. With a zero income tax rate, the after income tax yield on the muni is its before income tax yield. The after income tax yield on the taxable bond is
After income tax yield = Before income tax yield (1 - Marginal income tax rate)
Dividend income received from common stock and preferred stock is fully taxable. This is the double taxation noted above in the discussion of corporate income taxes.
Personal Capital Gains Taxes
Like corporate income, the personal income tax system has special provisions for long term capital gains that result from owning assets for more than one year. They also lead to tax timing options and us federal tax brackets as with corporate income, short term capital gains (or losses) that result from holding assets for less than the required one year are taxed as regular income. However, personal (long term) capital gains may be taxed at a lower rate because the maximum capital gains rate is currently 28%. Thus if your marginal ordinary rate is above 28% (such as 31%, 36% or 39.6%), your capital gains are taxed at the lower rate of 28%. The lower capital gains tax rate provides extra incentive to invest in assets such as stocks, real estate and more generally business.
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