364 CHAPTER 9 Financial Statements, Cash Flow, and Taxes
Of course, it is generally not possible to finance exclusively with debt capital, and
the risk of doing so would offset the benefits of the higher expected income. Still, the
fact that interest is a deductible expense has a profound effect on the way businesses are
financed—our corporate tax system favors debt financing over equity financing.This point is
discussed in more detail in Chapters 6 and 13.
Corporate Capital Gains Before 1987, corporate long-term capital gains were
taxed at lower rates than corporate ordinary income, so the situation was similar for
corporations and individuals. Under current law, however, corporations’ capital gains
are taxed at the same rates as their operating income.
Corporate Loss Carry-Back and Carry-Forward Ordinary corporate operating
losses can be carried back (carry-back)to each of the preceding 2 years and forward
(carry-forward)for the next 20 years and used to offset taxable income in those years.
For example, an operating loss in 2003 could be carried back and used to reduce tax-
able income in 2001 and 2002, and forward, if necessary, and used in 2004, 2005, and
so on, to the year 2023. The loss is typically applied first to the earliest year, then to
the next earliest year, and so on, until losses have been used up or the 20-year carry-
forward limit has been reached.
To illustrate, suppose Apex Corporation had $2 million of pre-taxprofits (taxable
income) in 2001 and 2002, and then, in 2003, Apex lost $12 million. Also, assume that
Apex’s federal-plus-state tax rate is 40 percent. As shown in Table 9-9, the company
would use the carry-back feature to recompute its taxes for 2001, using $2 million of
the 2003 operating losses to reduce the 2001 pre-tax profit to zero. This would permit
it to recover the taxes paid in 2001. Therefore, in 2003 Apex would receive a refund of
its 2001 taxes because of the loss experienced in 2003. Because $10 million of the
unrecovered losses would still be available, Apex would repeat this procedure for 2002.
Thus, in 2003 the company would pay zero taxes for 2003 and also would receive a re-
fund for taxes paid in 2001 and 2002. Apex would still have $8 million of unrecovered
losses to carry forward, subject to the 20-year limit. This $8 million could be used to
offset taxable income. The purpose of this loss treatment is to avoid penalizing corpo-
rations whose incomes fluctuate substantially from year to year.
Improper Accumulation to Avoid Payment of Dividends Corporations could
refrain from paying dividends and thus permit their stockholders to avoid personal in-
come taxes on dividends. To prevent this, the Tax Code contains an improper
TABLE 9-9 Apex Corporation: Calculation of Loss Carry-Back and Carry-
Forward for 2001–2002 Using a $12 Million 2003 Loss
200 12002
Original taxable income $2,000,000 $ 2,000,000
Carry-back credit 2,000,000 2,000,000
Adjusted profit $ 0 $ 0
Taxes previously paid (40%) 800,000 800,000
Difference Tax refund $ 800,000 $ 800,000
Total refund check received in 2003: $800,000 $800,000 $1,600,000
Amount of loss carry-forward available for use in 2004–2023:
2003 loss $12,000,000
Carry-back losses used 4,000,000
Carry-forward losses still available $ 8,000,000
See Ch 09 Tool Kit.xls
for details.
360 Financial Statements, Cash Flow, and Taxes
