Double Taxation of Capital Gains and Dividends

At 35%, the United States has the second highest corporate tax rate in the industrialized world.  Through their ownership, shareholders receive capital gains and dividends from these corporations.  Instead of the taxation ending at the corporate level, however, individuals also pay federal, state, and local taxes on these distributions.

Policymakers continually debate about what the optimal capital gains and dividend tax rates should be.  In fact, nearly every president since Gerald Ford has presided over a change to the long-term capital gains rate.  While interest income gets taxed as ordinary income, capital gains from investments held for over one year typically receive preferential tax treatment.

On January 1, 2013, capital gains and dividend rates increased for higher-income earners as depicted here:

Source:  http://www.forbes.com/sites/beltway/2012/01/24/capital-gains-taxes-are-going-up/

With this background, we can illustrate the effects of double taxation.  For simplicity, let’s assume:

·         100 people purchase all shares of a company for $1,000 each; the company is therefore worth $100,000

·         Over the next year, the company earns $20,000 pre-tax

·         35% corporate tax rate is applied à the company earns $13,000 after-tax

·         Each shareholder risked $1,000 of capital by investing in the company, and is entitled to fractional ownership of the company’s profits

·         An individual owns 1/100 of the firm, and would therefore receive (1/100) * $13,000 = $130 of profits through stock price appreciation or dividends

Because of double taxation, however, more deductions need to be calculated.  Most people need to add a 15% federal rate, plus state and local rate, to the tax burden.  This issue becomes even more acute for higher-income earners, where the effective federal tax is now about 25%.

If the (Federal + State + Local) tax rates on capital gains and dividends amounts to 30%, then the shareholder only receives $130 * 70% = $91.

Stocks are inherently risky to invest in because the firm’s creditors are entitled to cash before shareholders.  In this example, the company did well by earning $20,000 for its shareholders.  As a 1/100 owner of the company, you would be entitled to $200 pre-tax.

However, the corporate tax lowers this to $130, and then the capital gains and dividend taxes lower it further to $91.  The $91 represents merely 45.5% of what the company actually earned on a pre-tax basis, meaning that as an owner, you are subjected to an effective 54.5% tax rate.

Political discourse will continue about these issues, and hopefully this provides some helpful background material about corporate and individual tax rates. 

Source:  http://www.invigorlaw.com/choosing-a-business-entity-double-taxation-v-pass-through-taxation/