Many corporations cannot legally deduct dividend payments before taxes. When C corps pay dividends, their shareholders get hit twice. The company pays tax and then the shareholder pays a tax on it, too.
Not all companies are structured this way, though. Some companies are set up so that any income they make passes straight to their owners, shareholders, or investors. In these cases, the company isn't taxed on the dividend.
Key Takeaways
- Dividends are taxable to a corporation as they represent a company's profits.
- Shareholders are also taxed when they receive dividends. Although that tax rate is often more favorable than ordinary income, some see this as a double taxation.
- Companies not structured as C corps avoid this, with profits flowing directly to the owner(s).
- When a company is structured as an income trust, such as REITs, it can deduct dividends, or trust payments, before taxes are calculated.
What Is a Dividend?
A dividend is a disbursem*nt of a company's earnings to its shareholders or investors, usually in the form of cash. Because dividends represent a portion of net income, they are considered taxable as income from the company, and have a more favorable dividend tax rate to individuals. Not all companies pay out dividends. Some use net profits to reinvest in the company's growth and to fund projects where that money is accounted for as retained earnings.
Double Taxation of Dividends
If a company decides to pay out dividends, the earnings can be thought of as being taxed twiceby the government due to the transfer of the money from the company to the shareholders.
The first instance of taxation occurs at the company's fiscal year-end when it must pay taxes on itsearnings. The second taxation occurs when the shareholders receive the dividends, which come from the company's after-tax earnings. Theshareholders pay taxes firstas owners of a company that brings in earnings and then again as individuals, who must payincome taxeson their own personal dividend earnings.
This may not seem like a big deal to people who don't earn substantial amounts of dividend income, but it does bother those whose dividend earnings are large. Consider this: you work all week and get a paycheck from which tax is deducted. After arriving home, you give your children their weeklyallowances, and then anIRSrepresentative 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 payoutsdouble taxationof earnings is legal.
"Pass-Through" Entities
Not all dividend payments are subject to double taxation. It depends on how the company is structured.
Virtually all public companies are C corporations. With C corps, the company’s assets are separate from the owners’ assets. This limits the personal liability of the directors, shareholders, and so on. The downside, however, is that owners or shareholders get taxed separately.
Businesses organized as a “flow-through” or “pass-through” entity, such as sole proprietorships, partnerships, limited liability companies (LLCs), and S corporations, don’t experience such issues. Under this kind of structure, the profits flow directly to the owner(s). The business is not taxed separately.
Income Trusts and REITs
Income trusts are another example of a pass-through entity. With this type of corporate structure, a company can deduct dividends, or trust payments, before taxes are calculated. The essence of an income trust is to pay all of the earnings after all business expenses to the unit holders, who are the owners of the income trust.
Real estate investment trusts (REITs) are the most common corporate income trusts. These companies, which own and operate income-generating real estate, get special treatment in exchange for meeting certain rules. To qualify as a REIT, the bulk of assets and income must come from real estate and 90% of taxable income must be paid to shareholders. In other words, pretty much all of the earnings generated are directly passed to shareholders.
Are Dividends Calculated Before or After Tax?
That depends on how the company is structured. Most publicly traded companies are C corps, which means owners or shareholders get taxed separately. These companies are taxed before paying out dividends, so these payments come from after-tax earnings. Flow-through entities are different. With this structure, the company isn't taxed on the income it makes as it belongs to the owners or shareholders. Only these individuals—and not the entity itself—are taxed on revenues. The dividend is paid and then the recipient must pay tax on it.
Can a Corporation Deduct Dividends Paid to Shareholders?
C corporations pay tax on their income before paying dividends. For them, dividends are not a deductible expense.
When Should a Corporation Pay Dividends?
Dividend-paying corporations generally distribute payments to shareholders every quarter. Companies that pay dividends are typically established ones generating lots of excess cash. Investors love dividends and paying a decent one can boost share prices. However, they may not always be beneficial or appreciated. Money could maybe be better spent elsewhere, such as on acquisitions or growing the business. Such investments might generate higher overall returns for investors.
The Bottom Line
Shareholders of publicly traded companies will notice that with dividends, tax gets levied twice on the same income. First, the company pays taxes on profits, then the shareholders pay taxes on the proceeds that are distributed. That’s part of the downside of being a C corp and comes with the territory of separating a company’s assets from the assets of its owners.
Flow-through entities, such as REITs, don't have this problem. Being structured this way makes it possible to deduct dividends before taxes are calculated.
Dividends represent a portion of a company's profits distributed among shareholders, subject to taxation. When a C corporation pays dividends, it faces double taxation: the company is taxed on its earnings, and shareholders are taxed on the dividends received. This concept of double taxation is a significant aspect of corporate structure and taxation laws.
C corporations, commonly public companies, face this double taxation structure. Their assets are separate from the owners', but this separation results in separate taxation for the company and shareholders. Contrastingly, "pass-through" entities like sole proprietorships, partnerships, LLCs, and S corporations don't undergo this dual taxation. Profits flow directly to the owners, and the entity itself isn't taxed separately.
Income trusts, including Real Estate Investment Trusts (REITs), exemplify pass-through entities. These entities pass earnings to unit holders or shareholders after deducting dividends or trust payments before taxes. REITs specifically gain special treatment by meeting specific criteria, such as having the majority of assets and income from real estate and distributing 90% of taxable income to shareholders.
The treatment of dividends before or after tax depends on the company's structure. C corporations are taxed before paying dividends, using after-tax earnings for dividend payments. On the other hand, flow-through entities aren't taxed on their income, and only shareholders are taxed on revenues, including dividends received.
Regarding deductions, C corporations cannot deduct dividends paid to shareholders. However, dividend payments by corporations are often made quarterly, especially by established companies with excess cash. While dividends may please investors and boost share prices, companies might opt to invest in other avenues like acquisitions or business growth instead, potentially yielding higher returns.
In summary, the double taxation issue is a notable downside for shareholders of C corporations, while pass-through entities avoid this problem. Understanding the implications of corporate structure on dividend taxation is essential for investors and businesses alike in making informed financial decisions.
