How Do Corporations Avoid Paying Taxes?

It is a common perception that many large corporations pay little in federal income tax, often stemming from reports of profitable companies with a low tax bill. The methods used are typically not illegal tax evasion but rather a series of legal strategies known as tax avoidance. The U.S. tax code is a complex set of laws with provisions that allow companies to reduce their taxable income or final tax liability.

Corporate tax obligations are determined by a company’s taxable income, which is its total revenue minus allowable deductions. The strategies employed are built into the structure of the tax system and are available to any corporation that meets the specific requirements. Navigating these rules allows a company to legally minimize the amount of tax it owes, which is distinct from tax evasion that involves illegally hiding income or falsifying deductions.

Leveraging Deductions and Expenses

A primary method corporations use to lower tax obligations is by reducing their taxable income through deductions. For a business expense to be deductible, the Internal Revenue Service (IRS) requires it to be both “ordinary and necessary” for the company’s trade or business. An ordinary expense is common in a particular industry, while a necessary expense is helpful and appropriate for the business.

This concept allows companies to subtract the costs of doing business from their revenues before the corporate tax rate is applied. For example, expenses for advertising, office supplies, and employee salaries are all ordinary and necessary costs of operation and are therefore deductible. By claiming all eligible expenses, a corporation can decrease its taxable income and reduce its overall tax liability.

Depreciation

Corporations can deduct the cost of tangible assets they purchase, such as machinery, equipment, and buildings. Instead of deducting the full cost in the year of purchase, tax rules require the cost to be spread out over the asset’s useful life through a process called depreciation. The Modified Accelerated Cost Recovery System (MACRS) is the primary depreciation method used for tax purposes in the United States.

This system allows for larger depreciation deductions in the early years of an asset’s life and smaller deductions in later years. This “accelerated” aspect provides a timing benefit by lowering taxable income more substantially in the years immediately following a major purchase. This front-loading of deductions defers tax payments and improves a company’s cash flow in the short term.

The IRS classifies assets into different property classes, each with a specific recovery period that dictates how long the asset can be depreciated. For instance, computers are often in a 5-year class, while office furniture is in a 7-year class. Special provisions, such as bonus depreciation, have at times allowed companies to deduct a large percentage of the cost of qualifying assets in the first year, further accelerating the tax benefit.

Interest Expenses

Another deduction for corporations comes from the interest paid on debt. When a company borrows money by taking out loans or issuing bonds, the interest it pays is generally treated as a deductible business expense. This tax treatment lowers the cost of borrowing, creating an incentive to finance operations and investments with debt rather than equity, as dividends paid to shareholders are not deductible.

The deductibility of interest expenses encourages debt financing. A company might choose to borrow funds to build a new factory or acquire another business, and the interest payments on that loan reduce its taxable income. For example, if a corporation pays $10 million in interest on its bonds in a given year, that amount can be subtracted from its revenues when calculating its taxable profit.

There are limitations to this deduction. The Tax Cuts and Jobs Act of 2017 (TCJA) introduced a rule under Section 163(j) of the Internal Revenue Code that limits the amount of net business interest expense a company can deduct. The limitation is calculated as a percentage of the company’s adjusted taxable income, which for many businesses is 30% of their earnings before interest and taxes (EBIT). Many smaller businesses with average annual gross receipts below a certain threshold are exempt from this limitation.

Executive and Employee Compensation

The money a corporation spends on its workforce, including salaries, wages, bonuses, and benefits, is a major business expense that is deductible. This includes cash compensation paid to regular employees and the pay packages for top executives. These costs are considered necessary for running the business and can be subtracted from the company’s income, thereby lowering its taxable profits.

For publicly traded companies, there is a limitation on the deductibility of executive pay. Section 162(m) of the Internal Revenue Code restricts the tax deduction for compensation paid to certain top executives to $1 million per year for each executive. This rule applies to a company’s chief executive officer, chief financial officer, and the next three highest-compensated officers.

Any compensation paid to these “covered employees” above the $1 million threshold is not deductible by the corporation. The TCJA made this $1 million cap a much firmer ceiling for the most senior executives at public companies. Despite this limit, stock-based compensation, such as stock options and restricted stock units, remains a deductible expense for the corporation at the time the employee recognizes income from it.

Utilizing Tax Credits

While deductions reduce a company’s taxable income, tax credits provide a more direct benefit by reducing the final tax bill on a dollar-for-dollar basis. A $10,000 tax credit cuts the amount of tax owed by the full $10,000. The government creates tax credits to incentivize specific behaviors and investments considered beneficial to the economy or society, such as promoting innovation or clean energy.

These incentives are a form of government subsidy delivered through the tax code. By offering a credit, lawmakers encourage companies to spend money on certain activities they might not otherwise pursue. A business must meet specific requirements to qualify for a credit and apply it against its tax liability on its main tax return.

Unlike deductions for ordinary business expenses, credits are targeted at very specific expenditures that align with policy goals set by Congress. The availability and value of these credits can change as legislative priorities shift, making it an area of the tax code that requires close attention from corporate tax departments.

Research and Development (R&D) Credit

One of the most common corporate tax credits is the Credit for Increasing Research Activities, known as the R&D tax credit. This credit is designed to reward companies for investing in innovation and developing new or improved products, processes, or software within the United States. To qualify, the research activities must be technological in nature and involve a process of experimentation to eliminate uncertainty.

The credit is calculated as a percentage of the company’s qualified research expenses (QREs) over a base amount. QREs include the wages of employees conducting the research, the cost of supplies used in the process, and a portion of payments to contractors for research services. The credit can provide a substantial reduction in a company’s tax liability, lowering the after-tax cost of its innovation efforts.

Recent changes have altered how companies account for R&D expenses. Beginning in 2022, companies must capitalize and amortize their research expenditures over five years for research conducted in the U.S. (15 years for foreign research), rather than deducting them immediately. This change affects a company’s taxable income calculation, but the R&D credit remains a separate incentive that directly reduces the final tax owed.

Green Energy and Investment Credits

The federal government offers a suite of tax credits to encourage corporate investment in renewable and clean energy technologies. The most prominent of these are the Investment Tax Credit (ITC) and the Production Tax Credit (PTC). The ITC provides a credit based on a percentage of the investment cost for qualifying energy properties, such as solar, fuel cell, and geothermal projects.

For example, a corporation that installs a large solar panel array on its facility can claim the ITC, which can be as high as 30% of the project’s cost. The PTC provides a per-kilowatt-hour credit for electricity generated from qualifying renewable sources like wind. These credits make renewable energy projects more financially viable for businesses, lowering their energy costs and tax bills.

The Inflation Reduction Act of 2022 expanded and extended these green energy credits. It established credits for a wider range of technologies, including energy storage, clean hydrogen, and qualified commercial clean vehicles. The law also introduced provisions that allow companies to receive a larger credit if they meet requirements related to paying prevailing wages and using apprentices.

International Tax Strategies

Multinational corporations operate in a global marketplace, which presents opportunities for tax planning not available to domestic companies. By structuring operations across countries with varying tax laws, these corporations can legally minimize their worldwide tax burden. These strategies often involve the placement of assets, income, and expenses among subsidiaries in different tax jurisdictions.

The goal is to recognize profits in countries with low tax rates while booking expenses in countries with high tax rates. The complexity of international tax law allows for sophisticated structures governed by domestic laws, foreign laws, and international tax treaties. These same rules can create opportunities for companies to ensure some profits are taxed at very low rates.

The Organization for Economic Co-operation and Development (OECD) has led a global effort to combat Base Erosion and Profit Shifting (BEPS), which refers to strategies that exploit gaps in tax rules. Recent international agreements, such as the global minimum tax framework, aim to curtail these practices by ensuring large multinational enterprises pay a minimum level of tax regardless of where they book their profits.

Profit Shifting and Tax Havens

A core international tax strategy involves profit shifting, which is the practice of moving profits from high-tax countries to low-tax or no-tax jurisdictions, often called tax havens. A multinational corporation might generate significant sales in a country with a 25% corporate tax rate but legally report the bulk of the associated profits in a subsidiary located in a country with a very low tax rate.

This is often accomplished by locating valuable intangible assets, such as patents and trademarks, in a subsidiary based in a tax haven. The subsidiary in the high-tax country then pays large royalties to the tax haven subsidiary for the right to use this intellectual property. These royalty payments are a deductible expense in the high-tax country, while the income is received in the low-tax jurisdiction, where it is taxed minimally.

Jurisdictions like Bermuda, the Cayman Islands, and Ireland have historically been used for these purposes due to their favorable tax laws. While these strategies are legal, they have drawn scrutiny from governments for eroding the tax base of higher-tax countries. Studies have estimated that hundreds of billions of dollars in corporate tax revenue are lost annually worldwide due to profit shifting.

Transfer Pricing

The mechanism that enables much of this profit shifting is known as transfer pricing. This refers to the prices that related entities within a single multinational corporation charge each other for goods, services, or intellectual property. Tax authorities require these internal transactions to be priced at “arm’s length,” meaning the price should be the same as it would be between two unrelated companies.

This principle is intended to prevent companies from manipulating these prices to shift profits artificially. For example, a company could not simply have its subsidiary in a high-tax country sell goods to its subsidiary in a low-tax country for one dollar to move all the profit. The price must be justifiable based on what independent companies would charge.

Determining an appropriate arm’s-length price for unique intellectual property can be highly complex and subjective. The inherent difficulty in valuing unique assets provides leeway for companies to set prices that are advantageous for tax purposes, effectively shifting income to lower-tax jurisdictions.

Managing Losses and Gains

Beyond ongoing expenses and credits, corporations employ tax strategies that involve the timing and classification of their income and losses. The tax code treats different types of income and losses differently, and rules allow for losses in one year to affect the tax liability of another. By strategically managing when they recognize financial gains and how they utilize losses, companies can optimize their tax position across business cycles.

Net Operating Losses (NOLs)

When a corporation’s tax-deductible expenses exceed its income in a given year, it results in a net operating loss (NOL). The tax code allows the company to use this loss to reduce its tax liability in other years. Under current federal rules, NOLs can be carried forward indefinitely to offset taxable income in future years.

For example, if a startup incurs a $5 million loss in its first year, it can carry that NOL forward. If the company then earns a $3 million profit in its second year, it can use part of the NOL to completely offset that profit, resulting in no tax liability for that year. The remaining $2 million of the NOL can then be carried forward to offset profits in subsequent years.

There is a limitation on the use of NOLs. For losses arising in recent tax years, the NOL deduction is limited to 80% of the taxable income in the year the carryforward is used. This means a company with a large NOL cannot necessarily eliminate its entire tax bill in a profitable year; it can only reduce it by 80%.

Capital Gains

Corporations also manage their tax liability by considering the treatment of capital gains. A capital gain occurs when a company sells a capital asset—such as stocks, bonds, or real estate—for more than its purchase price. The tax rules distinguish between short-term gains (on assets held for one year or less) and long-term gains (on assets held for more than one year).

For corporations, a net capital gain is taxed at the same flat 21% rate as ordinary income. The strategic element for corporations lies in how they can use capital losses. A corporation can deduct capital losses to the full extent of its capital gains in a year. If a company has more capital losses than gains, it cannot deduct the excess loss against its ordinary operating income.

Instead, the excess capital loss can be carried back three years and forward five years to offset capital gains in those other tax years. This provision influences corporate decisions about when to sell assets. A company might choose to sell an asset that has appreciated in value during the same year it sells another asset at a loss, using the loss to offset the gain.