State corporate taxation of bond interest
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Investing in bonds has become more attractive as interest rates have increased. Higher rates mean taxpayers can earn more interest income from bond investments. But what are the state corporate income tax consequences?
Does it make sense to invest in tax-exempt bonds?
Some bonds can yield corporate tax-free income. Depending on a company’s taxable income and tax rate, interest that is exempt from state tax may be preferable to bonds that are not exempt even though they pay a higher rate.
Can states treat the taxability of their own bond interest differently than that of other states?
Interest income from federal, state, and local bonds may be tax-exempt in certain states. But some states prefer to limit the tax exemption to only specific types of bonds.
The constitutionality of taxing other states’ bond interest, but not a state’s own, was tested in Kentucky Department of Revenue v. Davis. The U.S. Supreme Court upheld the state tax treatment of municipal bond interest, where the interest on bonds issued by the state and its own localities is exempt, but not the interest on bonds issued by other states and their localities.
So, many states do exempt interest income from bonds issued by the state and its localities, while taxing interest income received from bonds issued by other states.
Do states tax federal bond interest?
Federal law prohibits any state from taxing the interest earned on U.S. obligations. However, this restriction does not apply to nondiscriminatory franchise taxes imposed on a corporation.
So whether the interest earned on U.S. government obligations is taxed in certain states depends on whether the tax is deemed to be a corporate income tax or nondiscriminatory franchise tax.
For example, since each of the Massachusetts corporation excises is a nondiscriminatory franchise tax, Massachusetts taxes the interest earned from U.S. government bonds.
Other states imposing a similar tax on interest from federal bonds include:
- New Jersey
- New York
Does the state tax interest on its own bonds?
Most states exempt interest from bonds issued by the state itself and its local governments. Exceptions include the states that tax U.S. government obligations and the following states.
However, even in these states income from certain specified obligations is exempt.
Does the state tax interest on other states' bonds?
Most states tax interest from bonds issued by other states and localities. There are a handful of exceptions.
How should a taxpayer decide on which bonds to buy?
When investing in bonds the taxpayer will want to consider the tax treatment of interest in the state or states where the corporation is subject to tax. The taxpayer should compare the returns between tax-exempt bonds and taxable bonds. Calculating the tax-equivalent yield will provide the taxpayer with the return that a taxable bond would need to pay in order to equal the yield on a comparable tax-exempt bond.
There are a number of factors a corporate taxpayer should consider when buying bonds.
- What is the applicable corporate tax rate?
- What is the amount of taxable income attributed to the taxing state?
- Does the corporation have a tax loss?
Depending on the taxpayer’s situation, investing in bonds with the higher interest rate may not yield the best result.