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Corporations Are Taxpayers, Too

Double Taxation of Dividends

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Corporations, like individuals, pay tax on their income, specifically on their receipts minus their expenses. Those expenses include wages, depreciation, capital expenses and a range of other costs, including the interest they pay to bondholders and other lenders.

In 2008, corporate income taxes provided about 12 percent, or $354 billion, of U.S. tax revenue, according to the Tax Policy Center of the Urban Institute and the Brookings Institution. Individual taxpayers paid 45 percent of the total. Of the balance, payroll taxes — half paid by workers and the other half by their employers — accounted for 36 percent of revenue, excise taxes for 3 percent and a combination of other sources for the rest.

Taxes and Investors

The interest that corporations can usually deduct on their tax returns has particular relevance for investors because it encourages corporations to raise capital with debt rather than equity — that is, by selling bonds rather than issuing stock. There’s no comparable tax deduction for the dividends a corporation pays its shareholders.
In fact, dividends are taxed twice, once at the corporate level and again at the individual shareholder level. But through 2010, individual shareholders pay tax on qualifying corporate dividends at a maximum rate of 15 percent, or between 10 and 20 percentage points lower than their marginal federal tax rate, which can be as high as 35 percent. Taxpayers whose marginal rate is 10 percent or 15 percent currently pay no tax at all on qualifying dividends (or on long-term capital gains). Whether these tax breaks will continue in 2011 and later is uncertain.
Ironically, though, investors get no comparable tax break on interest income. Corporations can deduct what they pay out, but bondholders pay tax on the interest earned at their marginal rate — up to 35 percent.

Reducing the Tax Bite

There are several ways that investors can limit the tax impact of both dividends and interest. For example, they can choose to own corporate bonds and dividend-paying stocks in a tax-free retirement account such as a Roth individual retirement account or a Coverdell education savings account.  
In addition, taxpayers may have a smaller tax burden if the stocks they hold pay no dividends but do increase in value over time and can be sold for a capital gain. This may happen if corporate boards decide to hold, or retain, earnings and use the money for acquisitions, expansion or other business purposes. If the uses to which the retained earnings are put increase the value of its stock, shareholders have a greater potential to realize a gain when they do sell.
On the other hand, dividends have historically formed a significant component of total return for many investors (see “Dividend Growth Screen,” page 23), so shareholders may prefer to receive dividends rather than relying solely on the potential for capital gains.

Tax Issues

Investors should also recognize that the way corporations are taxed is a political hot potato.
Critics of the current tax structure argue that the top 35 percent rate is too high. In their view, this situation makes it difficult for U.S. corporations to attract capital, limits their ability to create new jobs and impedes economic development. They advocate lowering the corporate tax rate to make the economy more competitive.
To support their position, they point out that although individual tax rates in the United States have decreased over the last 30 years, corporate tax rates have not. Over the last decade, they add, other countries have cut their corporate tax rates to increase their ability to compete for capital.
At the opposite end of the spectrum are those who maintain that corporations — especially the roughly 1,000 that can be characterized as large companies — don’t pay their fair share of the revenue the federal government collects.  
Among their criticisms, this group claims that large corporations use sophisticated tax shelters and take advantage of loopholes in the law to reduce the tax they might otherwise owe. They also point out that the corporate share of tax revenues has dropped dramatically, from an average of between 5 percent and 6 percent in the mid-19th century to 2 percent currently, while the share from individual returns has remained constant.  
How these issues will be resolved is unclear at this point, though corporate tax rates are certain to be on the federal legislative agenda in the short term.

Virginia B. Morris is the Editorial Director for Lightbulb Press.

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