What is the double taxation of dividends?

By Investopedia Staff AAA
A:

After all is said and done, 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.

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 Dividend Tax Rates: What Investors Need To Know and Dividend Facts You May Not Know.)

RELATED FAQS

  1. Why do some preferred stocks have a higher yield than common stocks?

    Before we answer this question, let's just take a quick review of what a stock's yield is actually measuring.The yield is ...
  2. Why would a company make drastic cuts to its dividend payments?

    A dividend cut occurs when a dividend paying company either completely stops paying out dividends (a worst-case scenario) ...
  3. Which is better a cash dividend or a stock dividend?

    The purpose of dividends is to return wealth back to the shareholders of a company. There are two main types of dividends: ...
  4. What happens during the spending/gifting phase of an investor's life cycle?

    The final phase(s) in an investor's life cycle is the spending/gifting phase, during which wealth accumulated over many years ...
RELATED TERMS
  1. PT (Perseroan Terbatas)

    An acronym for Perseroan Terbatas, which is Limited Liability ...
  2. Ltd. (Limited)

    An abbreviation of "limited," Ltd. is a suffix that ...
  3. BHD (Berhad)

    The suffix Bhd. is an abbreviation of a Malay word "berhad," ...
  4. AG (Aktiengesellschaft)

    AG is an abbreviation of Aktiengesellschaft, which is a German ...
  5. GmbH

    GmbH is an abbreviation of the German phrase Gesellschaft mit ...
  6. N.V. (NV or Naamloze Vennootschap)

    An acronym for the Dutch phrase Naamloze Vennootschap, a public ...
comments powered by Disqus
Related Articles
  1. Digging Into The Dividend Discount Model
    Markets

    Digging Into The Dividend Discount Model

  2. The Power Of Dividend Growth
    Investing Basics

    The Power Of Dividend Growth

  3. Using Life Insurance To Make Charitable ...
    Home & Auto

    Using Life Insurance To Make Charitable ...

  4. 5 Tax(ing) Retirement Mistakes
    Retirement

    5 Tax(ing) Retirement Mistakes

  5. 10 Steps To Tax Preparation
    Taxes

    10 Steps To Tax Preparation

Trading Center