When a business makes a profit, it has to pay taxes on this money to the Internal Revenue Service. Many businesses also choose to distribute dividends to investors in the company. If you are a business owner or thinking about starting a business, you need to understand how corporations are taxed in relation to dividends.
C Corporation Taxes
C corporations are a type of business entity that can issue dividends to investors. With this type of business structure, the company can make a profit and file its own tax return. To calculate the taxable income for the company, it can deduct certain expenses such as overhead and interest payments. Then the amount left over is taxed at a marginal tax rate. At that point, the dividends can be distributed to the investors in the company.
With this tax system, the same profit essentially gets taxed two times. The company has to pay taxes on the money that it receives in profit when it files its tax return. Then the company distributes that money to the shareholders of the company. Once the shareholders receive the money from the company, they also have to pay taxes on it as part of their personal tax returns. This means that the IRS takes a portion of the money on two separate occasions.
To avoid double taxation, some companies refrain from issuing dividends to their shareholders regularly. Instead, they can take what is left over from business operations and reinvest it into the company. By doing this, the company can grow the business operations and potentially provide greater capital appreciation in the value of the stock for the investors instead of giving them a regular dividend payment. More established companies that have saturated their market may tend to issue larger and more regular dividends.
When a company does not wish to be taxed as a C corporation, it can elect to be taxed as an S corporation. With an S corporation, it does not pay any taxes on the profit that it generates at the corporate level. Instead, all of the money that is generated from the business is passed onto the individual shareholders of the company. While this is not necessarily considered a dividend, it gets the money to the shareholders without being taxed twice.