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
Most commonly, double taxation happens when a company earns a profit in the form of dividends. The company pays the taxes on its annual profits first. Then, after the company pays its dividends to shareholders, shareholders pay a second tax.
What is double taxation of dividends? ›
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.
How do you avoid double taxation on foreign dividends? ›
However, to avoid double taxation—being taxed both in the source country and the US—taxpayers may claim a Foreign Tax Credit (FTC) if they paid taxes on these dividends to the foreign country. This credit reduces the US tax liability on a dollar-for-dollar basis for the amount of foreign taxes paid.
Why is double taxation a problem? ›
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 ...
Do you pay taxes twice on reinvested dividends? ›
The IRS considers any dividends you receive as taxable income, whether you reinvest them or not. When you reinvest dividends, for tax purposes you are essentially receiving the dividend and then using it to purchase more shares.
How many taxes do you pay on dividends? ›
How dividends are taxed depends on your income, filing status and whether the dividend is qualified or nonqualified. Qualified dividends are taxed at 0%, 15% or 20% depending on taxable income and filing status. Nonqualified dividends are taxed as income at rates up to 37%.
How do you avoid double taxation? ›
How to Avoid Double Taxation
- Retaining corporate earnings. You can avoid double taxation by keeping profits in the business rather than distributing it to shareholders as dividends. ...
- Pay salaries instead of dividends. You can distribute profit as salaries or bonuses instead of as dividends. ...
- Split income.
Of all the options for avoiding US double taxation, the most reliable is the Foreign Tax Credit. In fact, this credit was instituted for the sole purpose of warding off double taxation for Americans living abroad.
Do US citizens have to pay double tax? ›
The US is one of the few countries that taxes its citizens on their worldwide income, regardless of where they live or earn their income. This means that American expats are potentially subject to double taxation – once by the country where they earn their income, and again by the United States.
Is there a way to avoid tax on dividend? ›
You may be able to avoid all income taxes on dividends if your income is low enough to qualify for zero capital gains if you invest in a Roth retirement account or buy dividend stocks in a tax-advantaged education account.
Dividends are the money you get from company profits if you're a company shareholder, and dividend tax is simply the tax you'll have to pay on these dividends. Dividend tax rates are different from (and lower than) income tax rates, and you'll also get a tax-free dividend allowance.
What is an example of a double tax? ›
Examples of Double Taxation
The United States' tax code places a double-tax on corporate income with one tax at the corporate level through the corporate income tax and a second tax at the individual level through the individual income tax on dividends and capital gains.
What are the negative effects of double taxation? ›
Hence, double taxation induces a hardship on taxpayers through an increased tax burden on the investor and can result in the increase of the price of goods and services, discourages cross border investment through curtailing capital movement, and violates the tax fairness principle.
Is it better to reinvest dividends or take cash? ›
It May Take Longer To Achieve Long-Term Financial Goals: Dividend reinvestment leads to compounded growth. This makes it easier (and faster) to achieve your long-term financial goals versus keeping cash in a savings account.
At what age do you not pay capital gains? ›
Capital Gains Tax for People Over 65. For individuals over 65, capital gains tax applies at 0% for long-term gains on assets held over a year and 15% for short-term gains under a year. Despite age, the IRS determines tax based on asset sale profits, with no special breaks for those 65 and older.
When to stop reinvesting dividends? ›
Here are three common examples of situations in which it makes sense to not reinvest dividends:
- Balancing your portfolio. Reinvesting dividends will increase your position in the company paying them. ...
- Phasing out risk. In many cases, it's a good idea to make your investments less aggressive over the years. ...
- Income.
Examples of Double Taxation
The United States' tax code places a double-tax on corporate income with one tax at the corporate level through the corporate income tax and a second tax at the individual level through the individual income tax on dividends and capital gains.
What is the double taxation of dividends typically refers to? ›
Most commonly, double taxation happens when a company earns a profit in the form of dividends. The company pays the taxes on its annual profits first. Then, after the company pays its dividends to shareholders, shareholders pay a second tax.
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.
Are qualified dividends taxed twice? ›
For qualified dividends, the taxes on dividends are subject to the same 0%, 15%, or 20% tax rate that applies to the long-term capital gains rate for the various tax brackets. Most regular dividends are qualified.
