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. If I reinvest my dividends, are they still taxable?

    Take a brief look at how the Internal Revenue Service taxes different kinds of dividends, including taxation on dividends ... Read Answer >>
  2. Why do some companies pay a dividend, while other companies do not?

    Dividends are corporate earnings that companies pass on to their shareholders. There are a number of reasons why a corporation ... Read Answer >>
  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: ... Read Answer >>
  4. Can dividends be paid out monthly?

    Find out if stocks can pay dividends monthly, and learn about the types of companies most likely to do so and how monthly ... Read Answer >>
  5. How do dividends affect retained earnings?

    Find out how distribution of dividends affects a company's retained earnings, including the difference between cash dividends ... Read Answer >>
  6. What are some possible red flags in a company's dividend payout ratio?

    Read about how investors and analysts use the dividend payout ratio to scrutinize the sustainability of a company's dividend ... Read Answer >>
Related Articles
  1. Investing Basics

    How Dividends Work For Investors

    Find out how a company can put its profits directly into your hands.
  2. Fundamental Analysis

    Why Dividends Matter

    Seven words that are music to investors' ears? "The dividend check is in the mail."
  3. Taxes

    Explaining Double Taxation

    Double taxation refers to income taxes being imposed twice on the same source of earned income.
  4. Investing Basics

    Reinvesting Dividends Pays in the Long Run

    Find out why dividend reinvestment is one of the easiest ways to grow wealth, including how this tactic can increase your investment income over time.
  5. Investing News

    Understanding How Mutual Funds Pay Dividends

    The process by which mutual fund dividends are calculated, distributed and reported is fairly straightforward in most cases. Here's a look.
  6. Trading Strategies

    Introduction To Dividends: Introduction

    A dividend is a distribution of a portion of a company's earnings to a class of its shareholders. Dividends can be in the form of cash, stock, and less commonly, property. Most stable companies ...
  7. Investing Basics

    3 Tax Implications of Dividend Stocks

    Dividend paying companies are attractive in a low interest rate environment, but income seeking investors have to be careful of the potential tax hit.
  8. Mutual Funds & ETFs

    Reinvesting Your Mutual Fund Dividends

    Learn the benefits of reinvesting your mutual fund dividends, their impact over time, and when it is better to take the dividend payments as cash.
  9. Retirement

    Should Retirees Reinvest Their Dividends?

    Find out why dividend reinvestment may or may not be the right choice for retirees, depending on their financial needs and investment goals.
  10. Trading Strategies

    Introduction To Dividends: Investing In Dividend Stocks

    Many people invest in dividend-paying stocks to take advantage of the steady payments and the opportunity to reinvest the dividends to purchase additional shares of stock. Since many dividend-paying ...
RELATED TERMS
  1. Double Taxation

    A taxation principle referring to income taxes that are paid ...
  2. Dividends Received Deduction - DRD

    A tax deduction received by a corporation on the dividends paid ...
  3. Dividend Yield

    A financial ratio that shows how much a company pays out in dividends ...
  4. Accelerated Dividend

    Special dividends paid by a company ahead of an imminent change ...
  5. Accumulating Shares

    Common stock given to current shareholders of a company in place ...
  6. Forward Dividend Yield

    An estimation of a year's dividend expressed as a percentage ...
Trading Center