CHAPTER 15- TAXATION AND CORPORATE INCOME

8/14/2019 CHAPTER 15- TAXATION AND CORPORATE INCOME

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Chapter 15

Taxation of CorporateIncome


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Forms of Business

Sole Proprietorships

Partnerships

Corporations


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Corporations

Corporations are granted the legalstatus of people.

This means that they can own propertyand borrow money.


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Corporate Ownership

Corporations are owned by shareholders. Eachshare entitles its holder to a fraction of the

dividends declared,votes at shareholders meetings that determine the

operations of the corporation, and

proceeds if the corporation were to dissolve.

The fraction of all of the above that applies for eachshareholder is the number of shares held divided bythe total number of shares outstanding.


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Corporate Taxes

Corporations are subject to a corporateincome tax in the U.S.

Since the corporation is not really a person,the people who bear the burden of this taxdepend on the shifting of the tax.

The tax could be shifted backwards toemployees, shifted forward to consumers orborne by the shareholders.


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The Tax Base: Measuring Business Income Using the comprehensive definition of income,

business income is receipts + net capital gains

income labor, interest, material, and otherbusiness costs.

In the U.S., only realized capital gains areincluded in net taxable income forcorporations.


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Taxation of Owner-Supplied Inputs

In small business settings, owners work forthemselves. The profit from the business iswhat each owner is paid.

Some of this is normal profit; some iseconomic profit.

Corporations feature no owner-supplied inputso all profit, normal and economic, is taxed.


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Corporate Profits and Where They Go

Corporate Profits = Corporate Taxes +Retained Earnings + Dividends

Retained Earnings are the portion of after-taxcorporate profits that a company keeps toinvest in the business.

Dividends are the portion of after-taxcorporate profits that are distributed toshareholders.


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Economic Depreciation Economic Depreciation is the amount of

value that an asset loses over time.

When a business buys an expensive capitalasset, it cannot deduct from corporate profitsthe entire value of the asset.

Because the asset will be productive for asubstantial period of time, companies canonly deduct a portion of the value of theasset.


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Inflation and Depreciation

If inflation is running at a significant pace,then the replacement cost for a capital

asset can be higher than the valueremaining on the books.

Depreciation is understated if firms areonly allowed to use historic costs.


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Undistributed Corporate Profits,

Dividends, And Interest Cost

Some argue that a separate corporate income

formula is necessary to reverse the tax preferencethat comes from the exclusion of all unrealizedcapital gains in calculating personal income tax.

Others counter that because payment on corporatedebt (interest) is deductible to the corporation butpayment on equity (dividends) is not, a separatetax on corporate income is neutral.


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Double Taxation of Corporate Income

Corporate Income is considered to be double-taxed,because its income is taxed twice.

The Corporation must pay taxes on the profits, then

shareholders must pay taxes on the amount theyreceive in either dividends or capital gains.

Under a comprehensive income tax this would nothappen. Corporate profits, either retained or paid individends, would enter individual income taxstructures according to the percentage of thecorporation owned by each shareholder.


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Arguments in Favor of Double Taxing

Corporate IncomeUnrealized Capital Gains and the Stepped-Up Basis:

A major source of unrealized capital gains forindividuals is corporate stocks. If the businessprofit were not taxed at the corporate level, itmight never be taxed.

Compensation for Bankruptcy Protection: Individuals are not liable for the bankruptcy of

assets they hold in corporations, whereas theyare liable in cases of proprietorships andpartnerships. This poses a real advantage toinvesting in corporations over the other businessforms.


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The Consequence of Double Taxation: A

Bias Toward Debt Finance A corporation can raise money by borrowing (taking on

debt), or it can raise money by selling stock.

The corporation can deduct from its profits the amountit pays in interest to its bondholders.

It cannot deduct the dividends it pays to itsstockholders. This encourages debt finance over

equity finance.


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Demonstrating the Bias toward Debt Finance

Item All-Equity 50% Debt 50% Equity

Balance Sheet

Total Assets $1,000,000 $1,000,000

Debt 0 $500,000Shareholders Equity $1,000,000 $500,000

Income Statement

Operating Income $150,000 $150,000

Interest Expense 0 $50,000

Taxable Income $150,000 $100,000

Income Tax $51,000 $34,000

Income afterCorporate Tax

$99,000 $66,000

Return on Equity 9.9% 13.2%

Assumptions:10% interest;34% tax rate

Conclusion: The taxation ofcorporate profits combinedwith the deductibility ofinterest raises the after-taxreturn on equity to firms ingreater debt, therebymotivating firms to increasetheir debt burdens to aninefficiently high level.


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Tax Treatment of Multinational Corporations

Large corporations with multinational operations haveforeign subsidiaries throughout the world.

The foreign subsidiaries are incorporated under thelaws of a foreign nation and are legally separate fromthe parent corporation.

There are two ways of taxing multinationals: Taxes only on repatriated profits. Computing worldwide income and granting a credit for tax

payments made to other countries.


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Rate StructureTaxable Income Average Tax

Rate at theBeginningof theBracket

MarginalTax Rate

Less than $50,000 0% 15%

$50K

CHAPTER 15- TAXATION AND CORPORATE INCOME

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