A little girl and her dad are eating ice cream and the little girl asks, “Daddy, what are taxes?” The dad kindly says, “Here, I’ll show you,” and then reaches over, scoops out half of her ice cream, and dumps it into his bowl. “That is taxes.”

Most of you have heard this story before, and a few of you have probably explained taxes with a story just like this. But for those of you who have and for those of you who are considering it, realize one thing: this is not how taxes actually work. As the election approaches and each side proposes their tax strategies to propel the economy out of its slump, it is absolutely imperative that the average American understands what the “corporate tax rate” is. 

The Corporate Tax Brackets

The reality of our tax system is extremely complex and for those of us who have lives and jobs – and not jobs as accountants or economists – trying to understand all the complexities of our federal budget would surely be futile. Most of us (especially journalists) rely on the highly-analytical reports delivered by different thinktanks, all of whom spend their days reading, analyzing, crunching numbers, and single-handedly keeping Starbucks’ P&L statements in the black. And even though all of those thinktanks add their own spin as to what the rates are and do, the federal government always publishes a tax table that is just numbers.

FY12 Corporate Tax Table

This may seem confusing, but just read it straight across, like this: the amount of money you make between the left column and the middle column is taxed at the rate in the right column. So if you make less than $50,000, your corporate tax rate is 15 percent. 

Let’s say you and I start a company and this year we report gross revenues of $235,000, close to the average annual income that an American small business generates. At first glance, it would seem that our tax rate is 39%, which equates to $91,650 in taxes. If this is the case, then out of the original $235,000 we made, we would only keep $143,350. And that hardly seems fair, right? 

This type of tax is called a “flat-rate tax,” and thankfully, this is not how our taxes are actually computed. Instead, our taxes are calculated progressively, meaning that different tax rates are applied to different intervals of revenue. But the average person is fooled by the corporate tax rate because they think that a business pays a set percentage of its total income in taxes.

This just isn’t the case!

To compute how much we would actually pay in income taxes, we determine what our top bracket is and then work backwards. The chart above indicates that for income between $100,000 and $335,000, the tax rate is 39%. Since we grossed $235,000, we can subtract $100,000 and get $135,000 in taxable income at the 39% tax rate. 

Next, we simple apply all remaining revenue to each respective tax bracket, like so:

As you can see, we only pay the top tax rate on the top $139,000, not the entire $230,000 that we grossed. So where we thought we would pay a flat tax of $91,650 on our $235,000, we would actually pay the following:

• On our first $50,000, our income taxes come out to be $7,500.
• On our next $25,000 (from 50k to 75k), our income taxes come out to be $6,250.
• On our next $25,000 (from 75k to 100k), our income taxes come out to be $8,500.
• On our last $135,000, our income taxes come out to be $54,210. 

So after adding up the taxes for each of our tax brackets, our total income taxes comes out to $76,460. This amount makes our effective tax rate - calculated by dividing how much we pay in income taxes by our taxable income – 32.53%, a difference from the flat-tax of $15,190.

This means that if we were taxed at a flat-rate, we would effectively be taxed at 32.53 percent. This is a very important number when it comes to accounting because a company’s effective tax rate can tell you a lot about where it hides invests its cash and other liquid assets. 

A few things are to be considered before moving forward:

• This does not account for deductions. Tax deductions are standard practice for anyone looking to pay less taxes. Corporations can amortize the value of assets purchased over the estimated use life of the asset, creating a tax deduction each year at a rate proportional to the length of the amortization. For example: Our company bought brand new computers for our whole office and we spent $30,000 for our sweet new set up. We estimate that we will buy new computers in three years due to changing technology requirements, wear and tear, and general electronic usability. On our balance sheets, we will deduct a percent of the total value of all the computers as a business expense over the estimated lifetime of the computers (3 years). Since we spent $30,000 in total, each year we would deduct $10,000 (1/3 of $30,000) from our taxable income and report it as a tax deductible amortized expense. In addition to these confusing scenarios, we can also deduct the cost of travel, payroll, office supplies, food, etc. All of these deductions take away from our total taxable income, sometimes (and preferably) pushing us into a lower tax bracket. 
• This is a very small, simple example. For instructional purposes I used basic terms like revenue and tax. In reality, a company generates gross revenue, from which is deducts overhead expenses (tax deductions). From there, the gross profit is calculated, and from the gross profit, income tax is calculated. In reality, if we had a company that grossed $235,000 in revenue, we would try to deduct as much as possible, earning a gross profit of closer to $200,000. This wouldn’t push us out of the 39% tax bracket, but it would save us $13,650 in income tax.

Corporate taxes can seem very confusing at first, but the key to understanding them is to know that every entity in America is taxed on a graduated scale (“progressively”), and when politicians talk about high corporate taxes, they’re talking about the top corporate tax rate, which applies only to companies with gross profits exceeding $18 million. Occasionally they will refer to the middle brackets, but not usually. 

So you should be taking away two things from this:

First, when someone says “that will push me into/out of a higher/lower tax bracket!” you should know that since we are taxed at a marginal rate that if that person makes an addition $5 that puts him into a higher tax bracket, only that $5 is taxed at the higher rate. And second, the next time you hear pundits talking about how our drastically high corporate tax rate of 35% is killing the economy and handicapping ”job creators,” just remember that those entities have to make over $18 million in profits (that means after deductions) to be affected. 

For more on this, learn about the smoke and mirrors of the term “small business” and Tax Changes for 2013.