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.)
First, let's understand what a dividend is. When a corporation makes a profit, it pays income tax on that profit, similar to the way individuals pay income tax on their wages and other income.What's left after the corporation pays income tax is known as "profit after tax" (PAT). A corporation with PAT can do two things with their PAT: (1) It can retain it in the business and either hold it as a reserve or invest it in new plant, equipment, R&D, etc.; and/or (2) It can distribute it to its shareholders. Such distributions are called "dividends." (Note: corporations with a history of profitability may choose to pay dividends even when the company is temporarily not earning profits.)
Apple Inc. earns huge PAT. The company has about 5.39 billion shares outstanding and currently pays $2.28 per share, per year in dividends to its shareholders. That amounts to about $12.3 billion in annual dividends paid, or roughly one-quarter of its PAT. If you are a shareholder of, say, 100 shares of Apple (symbol: AAPL), you receive $228 in dividends a year. You must report those dividends as income on your tax return. Depending on your tax bracket, you may pay tax on the dividends of as much as 20% of the $228, as well as state income tax, if applicable.
Because Apple paid tax on its profits, and then you paid tax on the dividends, some refer to this as double taxation of dividends. In fact, it is double taxation of corporate profits; the dividend itself is only taxed once. In order to avoid double taxation, some companies (for example, Berkshire Hathaway) choose not to pay a dividend. But many investors desire the steady income that dividends can provide.