Should a C Corporation Invest in Taxable or Municipal Bonds?

A C corporation -- a business entity that pays taxes and files returns -- has a wide range of bond investments to choose from. Investment options range from tax-free municipal bonds to fully taxable corporate bonds, but you may want to consider more than just the taxes when choosing the right bond for your corporation. Credit risk, liquidity and the overall return are additional factors worth consideration.

When investing in bonds, your corporation is actually lending money to an issuer, or borrower, which can be another corporation or a federal, state or local government agency. You earn money through the interest that accrues each year until the principal is paid back on the maturity date. Corporations pay federal income tax on the interest from corporate and U.S. Treasury bond investments. The interest on municipal bonds -- which are issued by state and local governments -- is nontaxable to corporations, as well as to individuals and other business structures.

The interest earned on corporate bonds is fully taxable in most states that charge a corporate income tax. Interest on U.S. Treasury bonds issued by the federal government, however, isn't taxable at the state level. Most states do require corporations to report the interest income earned on municipal bonds, but most jurisdictions won't tax the interest on municipal bonds issued by government agencies within the state. For example, if your C corporation operates in Georgia and pays income tax there, the interest your business earns from Georgia municipal bonds is tax free, though the interest from bonds issued outside of Georgia is fully taxable in the state.

In addition to taxes, corporate investors also consider a bond's liquidity and credit risk. A bond's liquidity refers to how fast your company can redeem it for cash. Generally, the shorter the loan term, the more liquid the bond is. For example, if your company needs the investment funds back after one year, a bond's liquidity may be more important than the tax implications. You can, however, always sell bonds in the open market before their maturity dates if the business needs cash. There is also the possibility that a bond issuer will default on repayment, which means your corporation can lose all or part of its investment. This credit risk tends to be higher with corporate bonds than with municipal and U.S. Treasury bonds.

Because bond interest rates vary depending on the maturity date, credit risk and other market factors, a tax-free municipal bond won't necessarily provide your corporation with the highest net return. To illustrate, suppose you're debating between a municipal bond that pays annual interest of $1,000 and a corporate bond that pays $1,800. Despite not having to pay tax on the $1,000 of municipal bond interest, the corporate bond yields a larger net return, because even after paying a 35 percent corporate income tax on the $1,800, your corporation is left with $1,170.