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.
FAQs
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.
How are dividends double taxed? ›
Double taxation occurs when taxes are levied twice on a single source of income. Often, this occurs when dividends are taxed. Like individuals, corporations pay taxes on annual earnings. If these corporations later pay out dividends to shareholders, those shareholders may have to pay income tax on them.
What is double taxation Quizlet? ›
Double taxation means that the: corporation pays taxes on its earnings and the shareholders pay taxes on the dividends received from the corporation.
What is double taxation group of answer choices? ›
Double taxation refers to the act of paying income taxes twice on the same income. It can occur in three scenarios, explained below: Income from corporations taxed for the corporation and its members. International investment or international trade.
What does the term double taxation mean ____? ›
double taxation. Occurs when governments tax profits at the corporate level and dividends at the personal level. The primary goal of a publicly owned corporation should be to. Maximize the price per share.
How does double taxation work? ›
Double taxation occurs when a corporation pays taxes on its profits and then its shareholders pay personal taxes on dividends or capital gains received from the corporation. A financial advisor can answer questions about double taxation and help optimize your financial plan to lower your tax liability.
What is the double dividend? ›
It refers to the notion that environmental taxes can both reduce pollution (the first dividend) and reduce the overall economic costs associated with the tax system by using the revenue generated to displace other more distortionary taxes that slow economic growth at the same time (the second dividend).
What does the double taxation of dividends typically refer to quizlet? ›
The double taxation of dividends typically refers to: A) dividends being taxed first as corporate profits and then as income after being paid to stock holders.
Which of the following is an example of double taxation? ›
When a corporation pays out dividends to shareholders, the dividends also have tax liabilities. Shareholders who receive any dividends must pay taxes on them. Hence, double taxation.
What is the concept of double taxation applies to shareholders of quizlet? ›
Double taxation applies to corporations because earnings are taxed both at the corporate level and the shareholder level when earnings are distributed in the form of dividends.
You can avoid double taxation by keeping profits in the business rather than distributing it to shareholders as dividends. If shareholders don't receive dividends, they're not taxed on them, so the profits are only taxed at the corporate rate.
Why is double taxation bad? ›
Opponents of double taxation on corporate earnings contend that the practice is both unfair and inefficient, since it treats corporate income differently than other forms of income and encourages companies to finance themselves with debt, which is tax deductible, and to retain profits rather than pass them on to ...
What is double taxation Chegg? ›
A sole proprietorship must pay income taxes to both the state government and the federal government.
What are the benefits of double taxation? ›
Benefits of the double taxation treaty
For international businesses, a double taxation treaty helps reduce additional tax burdens. Without this type of treaty in place, income could be taxed both in the country of earnings as well as after it's been repatriated to the home country.
Is double taxation positive or negative? ›
The double taxation of dividends is often cited as one of the disadvantages of the corporate form of business organization.
Which source of investor income is susceptible to double taxation? ›
Answer and Explanation:
Dividends are the source of income that is susceptible to double taxation because it is an income that leads to double taxation at an economic level.
How do you avoid double tax on dividends? ›
One way corporations can reduce the sting of the double tax is to retain earnings rather than pay them out in dividends. If the retained earnings are in- vested wisely by the corporation, each dollar of re- tained earnings should increase the value of the firm, which raises its share price.
Are dividends double taxed in the US? ›
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.
Are you taxed twice if you reinvest dividends? ›
While reinvesting dividends can help grow your portfolio, you generally still owe taxes on reinvested dividends each year. Reinvested dividends may be treated in different ways, however. Qualified dividends get taxed as capital gains, while non-qualified dividends get taxed as ordinary income.
How does an S Corp avoid double taxation? ›
Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income.
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