This morning, the Government Accountability Office (GAO) published a report on corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. es, which found that 19.5 percent of “profitable large corporations” paid zero corporate income taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. es in 2012.
Senator Bernie Sanders, whose campaign has been circulating the report, had this to say:
“There is something profoundly wrong in America when one out of five profitable corporations pay nothing in federal income taxes… We need real tax reform to ensure that the most profitable corporations in America pay their fair share in taxes. That means closing corporate tax loopholes to raise the revenue necessary to rebuild America and create millions of jobs.”
Should you be as outraged as Senator Sanders about the number of U.S. corporations that pay no corporate income tax?
In fact, there is good reason to think that many of the corporations that the GAO identifies as “profitable” did not actually earn a profit. In such cases, it would have been a mistake to collect corporate income taxes from these companies.
Defining Profitable Corporations
To understand why some unprofitable corporations might have been considered profitable by the recent GAO report, we need to distinguish between three concepts: book incomeBook income is the amount of income corporations publicly report on their financial statements to shareholders. This measure is useful for assessing the financial health of a business but often does not reflect economic reality and can result in a firm appearing profitable while paying little or no income tax. , taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. , and economic profit.
- Book income refers to the income that a corporation reports on its publicly filed financial statement. Corporations generally seek to report book incomes that are as high as possible, in order to appear as profitable as possible to their shareholders.
- Taxable income refers to the amount of income that a corporation reports on its tax return. Much of the U.S. tax code is devoted to defining corporate taxable income, which often differs somewhat from book income. Corporations with more than $10 million in assets are required to file Schedule M-3 to reconcile their book income with their taxable income.
- Economic profit refers to a company’s revenues minus its expenditures. There are a few important differences between book income and economic profit, as described below.
The recent GAO report defines “profitable large corporations” as “those that did not report net losses in their financial statements.” In other words, the GAO’s 19.5 percent statistic applies to corporations with positive book income in 2012.
However, there are many clear-cut cases in which a corporation with positive book income should not owe federal corporate income taxes:
1. Corporations with Carried-Forward Net Operating Losses
Especially over the last decade, many U.S. corporations have experienced volatile earnings, with large gains in some years and large losses in other years. The U.S. tax code allows companies with losses in one tax year to deduct those losses from their profits in future tax years.
To see why this is important, imagine a company that had $3 million in losses in 2014 and made $1 million in profits in 2015. Over the two-year period, the corporation experienced a net loss, and should not be required to pay corporate income taxes on its income over that period.
The deduction for carried-forward losses allows the corporation to reduce its tax liability in 2015 to zero, to reflect that it still recovering from past losses. But if the company were not able to carry its losses forward, it would owe a positive tax liability in 2015, even though it made a net loss over the two year period.
Tax liability if the corporation is not allowed to carry losses forward
In all likelihood, some of the “profitable” corporations in the GAO report that paid zero corporate income taxes in 2012 were carrying forward losses from past years. These corporations might have had positive book incomes in 2012, but might have had no taxable income, due to carried-forward losses from the Great RecessionA recession is a significant and sustained decline in the economy. Typically, a recession lasts longer than six months, but recovery from a recession can take a few years. .
The deduction for carried-forward losses is an important provision in the U.S. tax code, which prevents corporationAn S corporation is a business entity which elects to pass business income and losses through to its shareholders. The shareholders are then responsible for paying individual income taxes on this income. Unlike subchapter C corporations, an S corporation (S corp) is not subject to the corporate income tax (CIT). s with long-term net losses from being taxed. If some corporations in 2012 paid zero corporate income taxes because they were carrying forward past losses, this should be seen as a normal feature of the U.S. tax code, not a cause for concern.
2. Corporations with Foreign Profits and Domestic Losses
Many large U.S. corporations conduct business in multiple countries. It is likely that some of the corporations that were categorized as “profitable” by the GAO in 2012 did not actually earn positive profits in the United States.
As an example, we can imagine a U.S. multi-national corporation that brought back $2 million in 2012 from its overseas business but lost $1 million on its domestic business. Such a business would be categorized as profitable by the recent GAO report, because its total book income (foreign and domestic) adds up to $1 million.
|Total (book) income
However, there are good reasons why such a corporation would still face zero corporate tax under the U.S. law. The U.S. tax code offers corporations tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. s for the taxes they pay to foreign governments on their foreign income. The corporation in this example would probably be able to reduce its tax liability to zero by claiming a credit for the foreign taxes paid on its $2 million of overseas business income.
Foreign tax credits are a feature, not a bug, of the U.S. tax system. There are several good arguments for why U.S. corporations should not face U.S. corporate taxes on income earned abroad. Foreign tax credits help mitigate the double tax that arises when both a foreign government and the U.S. government try to tax the same foreign income.
To the extent that some of the “profitable” corporations in the GAO report earned only foreign profits, rather than domestic profits, it is entirely reasonable that these corporations should not be subject to any U.S. corporate tax burden.
3. Corporations with Large Capital Investments
The most important difference between book income, taxable income, and economic profit has to do with the treatment of investment costs. Under typical U.S. accounting standards, when a corporation makes a capital investment, it is only able to treat a small fraction of that investment as a current-year expense. However, the U.S. tax code allows corporations to treat a much larger fraction of the investment as a current year expense. Meanwhile, when calculating a corporation’s economic profit, it is appropriate to treat the entire cost of an investment as a current year expense.
As a result of these different calculation rules, a corporation with significant book income could have a much lower taxable income and an even lower economic profit. For example, we can imagine a corporation with $1 million in operating profits and $2 million in investment costs. Depending on how much of the investment the corporation treats as a current-year expense, the corporation could be making a large profit, no profit, or negative profit (see the example below).
Note: the calculation for book income assumes that the corporation depreciates 10% of its investment. The calculation for taxable income assumes that the corporation depreciates 50% of its investment. The calculation for economic profit treats the full cost of the investment as an expense.
This blog post is not the place to argue how corporations should treat their capital investments for tax purposes (although the Tax Foundation has pretty strong opinions about this). The important point is that some U.S. corporations with positive book income might have negative taxable income: not because of any tricks or loopholes, but simply because the tax code operates under different accounting rules.
It is likely that many of the “profitable” corporations that owed zero corporate tax in 2012 were corporations with significant capital investments, who had positive book income under one accounting method but zero or negative taxable income under another accounting method. These corporations are not evading taxes or taking advantage of loopholes; they’re simply less profitable according to the tax code’s definitions than they are according to the GAO’s.
In conclusion, there are real, legitimate reasons why a “profitable” corporation would not and should not be required to pay corporate income taxes in a given year. Politicians should avoid jumping to the conclusion that there is something “profoundly wrong” when a large minority of corporations do not pay corporate income taxes.Share