A dividend is a disbursement of cash profits to shareholders or investors. Because dividends represent a portion of net income, they are considered taxable as income from the company, and 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.

If you want to learn more about dividends, please read or article: "How and Why Do Companies Pay Dividends?"

Key Takeaways

  • Dividends are taxable to a corporation as they represent a company's profits.
  • Shareholders are also taxed when the receive dividends. Although that tax rate is often more favorable than ordinary income, some see this as a double-taxation.
  • Unit trusts are an organizational form that allows for tax-advantaged pass-through of dividends to shareholders as cash distributions.

Double Taxation of Dividends

If a company decides to pay out dividends, the earnings can be thought of as being taxed twice by 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 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.

Dividends and Unit Trust Taxation

Corporations may not legally deduct the dividend payments before taxes but there is another approach: a corporate structure called an income trust. Income trusts allow a firm to 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.

An income trust is essentially a corporation with a different classification under tax law. Income trusts are not permissible in most countries, but there are a few (Canada, for example) that still allow them, or a variation thereof. Because trust payments are paid out to unit holders in a cash-distributions-per-unit format before taxes are calculated, the corporation will have no income against which to calculate income taxes, virtually eliminating its tax liability.