Definition of Bonds and Stock
In this context, bonds refers to bonds payable, a form of long-term debt that typically promises to pay interest every six months and the principal amount at a specified maturity date. The interest expense associated with bonds payable is deductible from a U.S. corporation's taxable income. In other words, a profitable corporation will save paying income tax on the amount of the interest expense. The amount of the income tax savings depends on the amount of the interest expense and the corporation's federal and state incremental income tax rates.
In this context, stock usually refers to shares of common stock, which is evidence of an ownership interest in a corporation. Corporations decide whether it will distribute some of its earnings in the form of dividends to its stockholders. Dividends are not an expense and therefore do not reduce the corporation's net income or its taxable income.
Example of Tax Advantage of Bonds Instead of Stock
If a corporation issues $10,000,000 of bonds having 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 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 net cost of the borrowed money is reduced. In the above example in which the corporation had an incremental tax rate of 40%, its net cost of the borrowed money is $480,000 ($800,000 of interest minus $320,000 of income tax savings) or 4.8% ($480,000/$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 5.6% ($560,000/$10,000,000).