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Taxes

Taxes often have a major effect on financial decisions. Therefore, we should explain how corporations and investors are taxed.

CORPORATE TAX

Companies pay tax on their income. Table A.4 shows that there are special low rates of corporate tax for small companies, but for large companies (those with income over $18.33 million) the corporate tax rate is 35 percent. Thus for every $100 that the firm earns it pays $35 in corporate tax.

When firms calculate taxable income they are allowed to deduct expenses. These expenses include an allowance for depreciation. However, the Internal Revenue Service (IRS) specifies the rates of depreciation that the company can use for different types of equipment.9 The rates of depreciation that are used to calculate taxes may differ from the rates that are used when the firm reports its profits to shareholders.

The company is also allowed to deduct interest paid to debtholders when calculating its taxable income, but dividends paid to shareholders are not deductible. These dividends are therefore paid out of after-tax income. Table A.5 provides an example of how interest payments reduce corporate taxes.

The bad news about taxes is that each extra dollar of revenues increases taxable income by $1 and results in 35 cents of extra taxes. The good news is that each extra dollar of expense reduces taxable income by $1 and therefore reduces taxes by 35 cents. For example, if the firm borrows money, every dollar of interest it pays on the loan reduces taxes by 35 cents. Therefore, after-tax income is reduced by only 65 cents.

When firms make profits, they pay 35 percent of the profits to the Internal Revenue Service. But the process doesn`t work in reverse; if the firm takes a loss, the IRS does not send it a check for 35 percent of the loss. However, the firm can carry the losses back and deduct them from taxable income in earlier years, or it can carry them forward and deduct them from taxable income in the future.10