How Are Corporate Bonds Taxed?

A corporate bond is taxed in three ways—first through interest earned on the bond, then through capital gains or losses earned in the early sale of the bond, and finally through an original issue discount. The aggregate taxes owed on each of these components add up to equal the total amount of taxes owed on a corporate bond.

Interest 

The interest you earn from a corporate bond is subject to both federal income tax and state income tax. These are the normal taxes owed on a traditional corporate bond. Interest payments are normally known in both the size of the payment as well as the timing of the payment, which would allow the owner of the bond to calculate the exact amount of taxes he will owe on interest.

Capital Gains 

The taxes owed on capital gains or losses is less traditional than the taxes owed on interest because an investor can only receive capital gains from a corporate bond if he sells the bond prior to its maturity. If an investor decides to sell a bond for a gain prior to its maturity, the amount the investor receives above the original purchase price is considered a capital gain and is taxed at the investor's ordinary income tax rate. If the investor sells the bond after more than one year following its purchase, but it has not yet matured, he would be taxed at the long-term capital gains rate.

Issue Discount 

In some cases, a bond is issued at a price substantially less than the par value. When this happens, such as the purchase of a zero coupon bond, the difference between the par value and initial offer price is known as the original issue discount, and it is subject to taxes. This type of tax is complicated, and an investor should consult a tax professional if he is considering purchasing a bond with an original-issue discount.

Corporate Bonds vs. Other Bonds 

Although corporate bonds are the simplest form of a bond and are readily available, they are the least advantageous bond from a tax perspective. Nearly everything about a corporate bond is taxable. With that, however, corporate bonds pay the highest yields because they pose the highest default risk. 

Meanwhile, U.S. Treasuries, such as notes and bills, are taxed at the federal level but are exempt from state and local income taxes. Municipal bonds tend to offer the best tax advantages of all the bonds. They are exempt from federal income taxes, and if you buy them in the state where you live they are exempt from state and local taxes. 

On the other hand, there are zero-coupon bonds that have tax implications. These bonds are sold at a deep discount, relative to other bonds as they do not pay any interest or coupons. At maturity, the investor is paid the full face value. The catch is that the IRS will calculate the implied annual interest of the bond and charge you taxes annually, even though you don’t receive the money until maturity.