What is the tax advantage when bonds are issued instead of stock?
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.