The tax advantage of issuing bonds (or other debt) instead of stock results from the interest paid by the company being a deductible expense on its federal and state income tax returns. Dividends paid to stockholders are not a deductible expense, since dividends are a distribution of profits to the owners of the corporation.

The size of the advantage depends on the income tax rate of the company paying the interest. For example, if a corporation issues $10,000,000 of bonds with an interest rate of 8%, its annual interest expense will be $800,000. When the $800,000 of interest expense is entered on the corporation's income tax return, its taxable income will decrease by $800,000. If the corporation's combined federal and state income tax rate on this increment is 40%, the corporation will avoid or save paying income taxes of $320,000 ($800,000 of less taxable income X 40%). If the corporation's income tax rate on this increment is 30%, the corporation will save paying income taxes of $240,000 ($800,000 X 30%).

Due to the income tax savings, the cost of the borrowed money is reduced. For a corporation in the 40% tax bracket, its net cost of the borrowed money is $480,000 ($800,000 of interest minus $320,000 of income tax savings) for a net rate of 4.8% ($480,000 of net expense divided by $10,000,000). For a corporation with a combined tax rate of 30%, the net cost of the borrowed money will be $560,000 or a net rate of 5.6% of $10,000,000.

To learn more, see the Related Topics listed below: