33. The Snyder Corporation had the following income and expense items ! Sales $180,870,000 Cost 110,450,000 Expenses 65,560,000 In addition, it received both interest and dividends from the Bevins Corp, of which it owns 300. The interest received from Bevins was $2,430,000, and the dividends were $4,700,000. Calculate Snyder's tax liability. (Hint: See dividends paid to corporations, page 64.) 54 Part 1 Introduction to Financial Management INSIGHTS Practical Finance The Other Purpose of the Tax System The tax system in the United States has two purposes. The first of course, is to raise money. But the government also uses the system to incentivire what it considers desirable behavior. Sometimes these desirable ends are economic and sometimes they're social. Here are a few examples Lower taxes on capital gains and dividends make investment more profitable so people buy more stocks. That makes more funds available for business investment, so companies undertake more new projects. That, in turn, creates jobs and expands the economy. S-type corporations and LLC small businesses to escape double taxation while enjoying the other benefits of the corporate form. That encourage the formation of new companies, which creates jobs and expands the economy Companies get tax credits for employing and training certain types of unsked, difficult to employ people Tax Credits are available for money spent on restoring and preserving certain historical buildings. To see the point, we have to look beyond net income to the net amount retained by each firm after paying its investors. That is, we have to subtract dividends from net income to arrive at the net addition to retained earnings. The comparison follow Firm Financed by Debt Equity EBIT $120 $120 CODE Interest 20 EBT $100 $120 Tax @ 30% 30 36 Net Income $ 70 $ 84 Dividends Net RE addition $ 70 564 do gab Dividends paid to another corporation are partially tax exempt. Notice that the firm financed with debt gets to keep $6 more money, about 10% in this case. The difference is in the tax line. The debt-financed firm gets to deduct the payment to its investors before calculating taxes, while the equity financed business h as to pay tax on an amount that is not reduced by the dividend payment. Dividends Paid to Corporations In Chapter 1, we said that the major financial disadvantage of the corporate form is the double taxation of earnings. Earnings are first taxed as corporate profits and then taxed again as personal income when passed to shareholders in the form of dividends. But what happens if one corporation owns another that in turn is owned by individuals? Under those conditions, we'd expect triple taxation. To see this, consider Figure 2-2 in which corporation B is owned by corporation A, which is owned by individuals. It's easy to see that a dollar earned by B is taxed as income to B, as dividend income to A, and as dividend income to the shareholders. IfB owned corporation C C's earnings would be subject to quadruple taxation. Chapter 2 Financial Background: A Review of Accounting, financ e ments, and we FIGURE 2.2 Multiple Tanation Corporation Corporate toxon B Dividend BA Corporation A Corporate tax on A Dividend. A to shareholders Shareholders Personal Tox The government intends double taxation but not triple taxation and beyond. I therefore gives partial relief by exempting most of the dividends paid by one corporation to another from taxation as income to the receiving company The percentage exempted depends on the amount of B's stock owned by A. Ownership Exemption 80% 100% In our illustration, this means that if A owns 30% of B and B pays a dividend of $100 to A, A would declare only $20 as income in preparing its taxes. The remaining $80 would be exempt. Tax Loss Carry Back and Carry Forward Suppose that over a four year period a business had three good years and one with a substantial loss. If we consider each year individually, its earnings before tax, tax, and net income might be as shown at the top of Figure 2-3. (We are assuming a flat 30% tax rate to make the illustration simple.) At first glance, this looks reasonable. The company pays taxes when it has income and no tax when it has a loss. However, the business owner might very well claim that the IRS is putting him or her out of business if the tax system worked like this. The entrepreneur would point to the total column and claim that over the entire four-year period, the government was trying to make the business pay $90 in tax on 550 of earnings before tax. This would not only be unfair but impossible. recognizing this problem, the tax system allows businesses to spread the loss in year 3 among the years before and after. In this case, $100 of the year 3 loss would be carried back into each of years 1 and 2, entirely offsetting income in those years. After the loss year, the company would file amended tax returns for years 1 and 2 and receive refunds of the taxes paid. The remaining $50 of year 3 loss could be carried forward to reduce year 4 EBT. The idea is shown schematically in Figure 2-3. Losses can be carried back for 2 years and forward for as many as 20 years. Business losses can be carried backward or forward in time to offset taxes