How Corporate Bonds Are Taxed

Corporate bonds are subject to taxes on the interest earned, capital gains, and discounts on the issue. Interest earned, usually paid twice a year, is taxed at both the federal and state levels. Capital gains taxes apply only when the bond is sold. Compared to other types of bonds, corporate bonds face a higher tax burden but offer a higher yield.

Basics

Corporate bond taxation comprises three components. First, tax is applied to the interest earned on the bond. Second, it extends to capital gains or losses incurred during early bond sales. Lastly, an original issue discount is subject to taxation. The cumulative tax obligations from these components combine to represent the total corporate bond tax liability.

Taxation of Corporate Bond Interest

Interest income from corporate bonds is subject to federal and state income taxes. These standard tax liabilities apply to traditional corporate bonds. The interest payments, in terms of amount and schedule, are typically predictable, enabling bondholders to accurately calculate their tax obligations on interest earnings.

Capital Gains Tax on Corporate Bonds

Capital gains tax on corporate bonds differs from interest taxation. An investor can only realize capital gains by selling a corporate bond before maturity. Should an investor sell a bond for a profit before maturity, the gain above the original purchase price is treated as a capital gain and taxed at the investor's standard income tax rate. If the investor sells the bond after holding it for more than one year without reaching maturity, the long-term capital gains tax rate applies.

Issue Discount 

A bond may occasionally be sold for a lot less than its face value. The difference between the par value and first offer price in such cases, such as the purchase of a zero coupon bond, is referred to as the original issue discount and is taxed. An investor who is thinking about buying a bond with an original issue discount should speak with a tax expert since this form of tax is tricky.

Corporate Bonds vs. Other Bonds Taxation

Corporate bonds, while straightforward and accessible, are the least tax-efficient option among bonds. Virtually all aspects of corporate bonds incur taxation. Nevertheless, these bonds offer the highest yields due to their elevated default risk.

Tax Implications of Various Bonds

U.S. Treasuries, including notes and bills, are subject to federal taxes only and enjoy exemption from state and local income taxes. Municipal bonds offer the most favorable tax advantages, being free from federal income taxes, and when purchased in one's residing state, they are also exempt from state and local taxes.

Zero-Coupon Bonds and Taxation

Conversely, zero-coupon bonds have distinctive tax considerations. These bonds are sold at a significant discount compared to their interest-bearing counterparts, as they do not provide periodic interest or coupons. Upon maturity, the investor receives the full face value. The caveat lies in IRS taxation, as it computes the bond's implied annual interest and levies annual taxes despite the investor not receiving funds until maturity.

Conclusion

Corporate bonds face taxation on interest income, capital gains, and original issue discounts. Interest income is subject to federal and state income taxes, with predictable payment schedules aiding in tax calculations. Capital gains taxation applies when a bond is sold before maturity, with the tax rate dependent on the holding period. Original issue discounts present a complex taxation scenario, necessitating advice from tax professionals for potential investors. Despite higher tax burdens compared to other bond types, corporate bonds offer elevated yields, reflecting their inherent risk.