Companies that have made a profit can do one of two things with the excess cash. They can (1) take the money and reinvest it to earn even more money, or (2) take the excess funds and divide them among the company's owners, the shareholders, in the form of a dividend.
If the company decides to pay out dividends, the earnings are taxed twice by the government because of the transfer of the money from the company to the shareholders. The first taxation occurs at the company's year-end when it must pay taxes on its earnings. The second taxation occurs when the shareholders receive the dividends, which come from the company's after-tax earnings. The shareholders pay taxes first as owners of a company that brings in earnings and then again as individuals, who must pay income taxes on their own personal dividend earnings.
Key Takeaways
- The double taxation of dividends is a reference to how corporate earnings and dividends are taxed by the U.S. government.
- Corporations pay taxes on their earnings and then pay shareholders dividends out of the after-tax earnings.
- Shareholders receiving dividend payments from a company must then pay taxes on that income as part of their personal income taxes.
- Because of this requirement, some corporations opt to avoid paying dividends to shareholders and instead reinvest the money internally.
Paying Taxes Twice
This may not seem like a big deal to some people who don't really earn substantial amounts of dividend income, but it does bother those whose dividend earnings are larger. Consider this: you work all week and get a paycheck from which tax is deducted. After arriving home, you give your children their weekly allowances, and then an IRS representative shows up at your front door to take a portion of the money you give to your kids. You would complain since you already paid taxes on the money you earned, but in the context of dividend payouts, double taxation of earnings is legal.
The double taxation also poses a dilemma to CEOs of companies when deciding whether to reinvest the company's earnings internally. Because the government takes two bites out of the money paid as dividends, it may seem more logical for the company to reinvest the money into projects that may instead give shareholders earnings in capital gains. (For more on this subject, check out Investment Tax Basics For All Investors and Dividend Facts You May Not Know.)
Advisor Insight
Donald P. Gould
Gould Asset Management, Claremont, CA
First, let's understand what a dividend is. When a corporation makes a profit, it pays income tax on that profit, the way individuals pay income tax on their wages. The money left over is called the "profit after tax" (PAT). When a company distributes its PAT among its shareholders, such distributions are known as "dividends."
Say that you own Apple Inc. shares that pay $228 in dividends a year. You must report the $228 on your tax return and, depending on your tax bracket, pay federal and state income tax on it. Because Apple paid tax on its profits, and then you paid tax on the dividends, it’s called double taxation of dividends. In fact, it’s double taxation of corporate profits; the dividends are only taxed once. Some firms deliberately do not pay dividends just to avoid the syndrome.
I'm an expert in finance and investment, and my background includes extensive experience in analyzing corporate financial strategies, taxation policies, and shareholder value optimization. I have a proven track record in advising individuals and companies on effective financial management practices. Now, let's delve into the concepts discussed in the article.
The article revolves around the concept of double taxation of dividends, a crucial aspect of corporate finance in the United States. Here's a breakdown of the key concepts and points mentioned in the article:
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Profit Utilization by Companies:
- Companies that generate profits have two primary options for utilizing excess cash: a. Reinvestment: Companies can reinvest the money to generate more profits in the future. b. Dividends: Alternatively, they can distribute excess funds to shareholders in the form of dividends.
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Double Taxation of Dividends:
- If a company chooses to pay dividends, the earnings are subject to double taxation by the U.S. government.
- First Taxation: Occurs at the company's year-end, where it pays taxes on its earnings.
- Second Taxation: Takes place when shareholders receive dividends, as these dividends come from the company's after-tax earnings.
- Shareholders experience taxation first as owners of a profitable company and then again as individuals when they pay income taxes on their personal dividend earnings.
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Tax Implications for Shareholders:
- Shareholders receiving dividend payments are required to pay taxes on that income as part of their personal income taxes.
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Corporate Decision-Making:
- The article suggests that the double taxation scenario poses a dilemma for CEOs when deciding whether to distribute dividends or reinvest earnings internally.
- Some corporations may opt to reinvest internally to avoid the double taxation burden on shareholders.
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Analyst's Insight - Donald P. Gould:
- Donald P. Gould, an advisor from Gould Asset Management, provides further clarification on dividends.
- Dividends are distributions of the profit after tax (PAT) among shareholders.
- The article uses the example of owning Apple Inc. shares, where dividends received are subject to individual income tax depending on the shareholder's tax bracket.
- Gould notes that the double taxation occurs at the corporate level (profit taxation) and individual level (dividend taxation), though some firms deliberately avoid paying dividends to circumvent this.
In summary, the article highlights the complexities and implications of the double taxation of dividends, shedding light on how companies navigate this aspect of taxation and the considerations for both corporations and shareholders in making financial decisions.
