Interest Expense Vs. Dividend
Corporations issue stock securities and bond securities to obtain financing for company activities. Corporations often pay dividends to stockholders as a way of providing a return on their investment. Corporations face a legal requirement to pay interest to bondholders in exchange for the temporary use of their money.
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Interest Expense - Corporation
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Corporations who issue bonds face a legal liability to repay the amount borrowed plus make regular interest payments to the bondholder. The corporation may make these payments annually or semiannually. Interest payments represent an expense to the corporation which the corporation reports on its income statement. Interest expense reduces the company's net income for the period. Interest expense also reduces the company's taxable income and the amount of taxes the company owes. The corporation must also plan for the scheduled interest payments to ensure it has enough cash on hand to make these payments. Many companies set aside a portion of the interest payment each month so that it accumulates enough cash to make the payments when they come due.
Interest Revenue - Investor
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Investors purchase bonds because they expect to receive the required interest payments as scheduled. Because this represents a legal liability for the company, bonds hold little risk for the investor. If the company fails to make the interest payments, the bondholder can file legal action against the company. Interest payments represent revenue for the investor and must be reported as taxable income on the bondholder's income tax return.
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Dividend - Corporation
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Corporations who issue stock may pay dividends to the investors. Dividends occur at the discretion of the company's board of directors and are not required. However, companies with a history of paying dividends generally continue to do so. Changing the dividend structure creates the perception among investors that the company is struggling financially. Dividends represent a return of equity for the corporation, not an expense. Dividends do not reduce net income or taxable income.
Dividend - Investor
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Investors purchase stocks for the benefit of receiving dividend payments. Many investors choose to reinvest their dividends rather than receive payments. When an investor receives a dividend payment, she includes this on her income tax return as taxable income. This increases her income tax liability.
Impact on Net Profit
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Interest expense and dividends both share a relationship to net profit, although in different ways. The company reports interest expense on the income statement. The income statement calculates net profit by subtracting total expenses from total revenues. The interest expense reduces net profit. The company does not report dividends on the income statement, since it is not an expense. Companies do consider the net profit earned during the year when deciding whether to pay dividends.
Investment Interest
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If you borrow money to buy stock, the interest is tax deductible. Generally, the deduction in one year is limited to the net of your investment income, which is computed by subtracting all related expenses (except interest) from your gross investment income.
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