Tax benefits of debt
Encyclopedia
In the context of corporate finance
, the tax benefits of debt or tax advantage of debt refers to the fact that from a tax perspective it is cheaper for firms and investors to finance with debt
than with equity
. Under a majority of taxation systems
around the world, and until recently under the U.S. tax system
, firms are taxed on their profits
and individuals are taxed on their personal income
.
For example, a firm that earns $100 dollars in profits in the U.S. would have to pay around $30 dollars in taxes. If it then distributes these profits to its owners as dividends, then the owners in turn pay taxes on this income, say $20 on the $70 dollars of dividends. The $100 dollars of profits turned into $50 dollars of investor income.
If, instead the firm finances with debt, then, assuming the firm owes $100 dollars of interest to investors, its profits are now 0. Investors now pay taxes on their interest income, say $30 dollars. This implies for $100 dollars of profits before taxes, investors got $70 dollars.
This tax-related encouragement of debt financing has not gone uncriticized. For example, some critics have argued that the cost of equity should also be deductible; which could reduce the Internal Revenue Code
's influence on capital-structure decisions, potentially reducing the economic instability attributable to excessive debt financing.
Corporate finance
Corporate finance is the area of finance dealing with monetary decisions that business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize shareholder value while managing the firm's financial risks...
, the tax benefits of debt or tax advantage of debt refers to the fact that from a tax perspective it is cheaper for firms and investors to finance with debt
Debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
than with equity
Ownership equity
In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...
. Under a majority of taxation systems
Tax
To tax is to impose a financial charge or other levy upon a taxpayer by a state or the functional equivalent of a state such that failure to pay is punishable by law. Taxes are also imposed by many subnational entities...
around the world, and until recently under the U.S. tax system
Taxation in the United States
The United States is a federal republic with autonomous state and local governments. Taxes are imposed in the United States at each of these levels. These include taxes on income, property, sales, imports, payroll, estates and gifts, as well as various fees.Taxes are imposed on net income of...
, firms are taxed on their profits
Profit (accounting)
In accounting, profit can be considered to be the difference between the purchase price and the costs of bringing to market whatever it is that is accounted as an enterprise in terms of the component costs of delivered goods and/or services and any operating or other expenses.-Definition:There are...
and individuals are taxed on their personal income
Personal Income
In economics, personal income refers to an individual's total earnings from wages, investment enterprises, and other ventures....
.
For example, a firm that earns $100 dollars in profits in the U.S. would have to pay around $30 dollars in taxes. If it then distributes these profits to its owners as dividends, then the owners in turn pay taxes on this income, say $20 on the $70 dollars of dividends. The $100 dollars of profits turned into $50 dollars of investor income.
If, instead the firm finances with debt, then, assuming the firm owes $100 dollars of interest to investors, its profits are now 0. Investors now pay taxes on their interest income, say $30 dollars. This implies for $100 dollars of profits before taxes, investors got $70 dollars.
This tax-related encouragement of debt financing has not gone uncriticized. For example, some critics have argued that the cost of equity should also be deductible; which could reduce the Internal Revenue Code
Internal Revenue Code
The Internal Revenue Code is the domestic portion of Federal statutory tax law in the United States, published in various volumes of the United States Statutes at Large, and separately as Title 26 of the United States Code...
's influence on capital-structure decisions, potentially reducing the economic instability attributable to excessive debt financing.