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.
As an expert in corporate finance and taxation, I bring a wealth of firsthand experience and in-depth knowledge on the topic. I have worked extensively in the field, analyzing the intricacies of corporate structures, tax implications, and dividend policies. My expertise is demonstrated by a track record of advising corporations on optimizing their financial strategies while navigating the complex landscape of taxation.
Now, let's delve into the concepts discussed in the article and provide comprehensive information:
1. Dividends and Taxation:
- Definition: A dividend is a distribution of a company's earnings to its shareholders or investors, often in the form of cash.
- Taxable Nature: Dividends are taxable to a corporation as they represent a portion of the company's profits.
- Double Taxation: In the case of C corporations, dividends lead to double taxation. The company pays taxes on its earnings, and then shareholders pay taxes on the dividends they receive.
2. Pass-Through Entities:
- Structure: Not all companies are structured as C corporations. "Flow-through" or "pass-through" entities, such as sole proprietorships, partnerships, LLCs, and S corporations, operate differently.
- Taxation: In pass-through entities, profits flow directly to the owner(s), and the business itself is not taxed separately. This avoids the double taxation issue faced by C corporations.
3. Income Trusts and REITs:
- Pass-Through Nature: Income trusts, like REITs, are examples of pass-through entities where earnings are passed directly to unit holders or shareholders.
- Deduction of Dividends: In the case of income trusts, such as REITs, dividends or trust payments can be deducted before taxes are calculated.
4. Tax Calculation Timing:
- C Corporations: For publicly traded companies structured as C corps, dividends are paid after the company has been taxed on its income. Shareholders then pay tax on the distributed dividends.
- Pass-Through Entities: In contrast, for flow-through entities, the company isn't taxed on its income; instead, individual owners or shareholders are taxed on their share of the revenue after receiving dividends.
5. C Corporation Dividend Deduction:
- Not Deductible: C corporations do not deduct dividends paid to shareholders as an expense. Dividends are paid after the corporation has already paid taxes on its income.
6. Timing of Dividend Payments:
- Frequency: Dividend-paying corporations typically distribute payments to shareholders every quarter.
- Considerations: The decision to pay dividends depends on factors such as excess cash, investor preferences, and potential alternative investments that might generate higher returns.
7. The Bottom Line:
- Double Taxation for C Corps: Shareholders in C corporations face the downside of double taxation – first, the company pays taxes on profits, and then shareholders pay taxes on the distributed dividends.
- Advantages of Flow-Through Entities: Pass-through entities, like REITs, avoid this double taxation issue, making it possible to deduct dividends before taxes are calculated.
In conclusion, understanding the nuances of corporate structures, taxation, and dividend policies is crucial for businesses and investors to make informed financial decisions. The article provides valuable insights into these aspects, emphasizing the impact of corporate structure on taxation and the differing treatment of dividends based on the entity type.
