How is a corporate bond taxed?
A corporate bond is taxed through the interest earned on the bond, through capital gains or losses earned in the early sale of the bond, and through an original issue discount. The aggregate taxes owed on each of these components adds up to equal the total amount of taxes owed on a corporate bond.
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.
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.
In some cases, a bond is issued at a price substantially less than 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.