Are Dividends Deductible From Taxation?
Corporations in the United States can deduct their business expenses from their income tax, but the dividends they pay to the owners of their equity are not treated as expenses. Dividends, then, are not deductible.
Indeed, this is central to debates over the double taxation of corporate income. Dividends are taxed once because they are included in the taxable income of the corporation that issues them, and they are taxed again because they are included as part of the ordinary income of the individual who receives them.
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Corporate Taxes
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A corporation, in contrast to a partnership, is treated at law as an autonomous entity, a legal person. Consistent with this, a corporation is taxed on its own income, whereas a partnership is not.
Another common way of expressing this point is to say that a partnership is a "flow-through entity." Taxes are assessed at the level of the entity, but only applied, once, to the partners, according to Subchapter K, Chapter 1, of the Internal Revenue Code of the United States.
S Corporations
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Certain small businesses have long been allowed to escape double taxation through a Subchapter S election, first created by the Technical Amendments Act of 1958. Those corporations do so not through a dividend deduction, though, but by avoiding the corporate income tax altogether. The law as to "S corporations" has been amended repeatedly.
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Bad-Debt Deduction
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One issue that has arisen in the interpretation of Subchapter S involves the reclassification of "debt" as "equity," for purposes of eliminating the bad-debt deduction. In one case that came before the Tax Court in 1991, shareholders of a troubled C corporation had lent it money in hopes of reviving it. The corporation failed anyway, and the shareholders took a deduction for their now-worthless notes. The Internal Revenue Service contended that the so-called loan was actually an infusion of new equity, so the loss was not deductible. The Tax Court accepted the IRS argument. A workbook discussion on this case posted by the University of Illinois concludes, "The shareholders were limited to a capital loss on the worthlessness of stock..."
Twenty-First Century Debates
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Critics complain that the fact that corporations cannot deduct their dividend payments, by setting up "double taxation" of the same income, amounts to an inefficient tax system. They maintain that the tax code should be neutral as between different forms of doing business.
Defenders of the system argue, though, that the extra layer of taxation is a reasonable price for the benefits of the corporate form, such as the ease in raising capital and the protection of limited liability. As Confidence W. Amadi, an Associate Professor of Finance at Florida A&M University, wrote: "This price must be worth the benefits since ... corporations account for less than 20 percent of all U.S. business firms, but about 90 percent of U.S. business revenues and approximately 70 percent of U.S. business profits."
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