Over the last few years we have heard time and again that GW is going to cut the double taxation on dividends by making them tax free for investors. While that sounds like a good idea to some, let’s look at the realities of ‘tax-free’ dividends:
- Only individuals investing directly in stocks will benefit.
- There is no real incentive for companies to pay dividends
- The tax code is more complex due to no subtraction for this expense
If you own stocks through your company retirement plan, 401(k), SIMPLE, SEP, or Traditional IRA, all withdrawals from those plans are considered Ordinary Income just like a paycheck. No benefit from investing in tax free bonds exists now and certainly no benefit will exist in the future regarding dividends without an serious overhaul of the tax code- an overhaul that is not coming no matter what anyone says. Additionally, if you are invested in a ROTH IRA all your withdrawals are tax free as long as you meet the basic rules of the ROTH since you pay tax on the money when you earned it in your paycheck. No benefit of the ‘tax-free’ dividend will be seen by you.
The way dividends currently work at the corporate level, the corporation pays tax on its net earnings. Net earnings include the amount of dividends paid out. In other words, the corporation does not subtract what is arguably an expense from its earnings. This is the main reason Subchapter S corporations are popular with small corporations; taxes are only paid on one, level the individual share holders. The S Corp itself pays no taxes (well there are a couple different ones they do pay but not generally on regular income) but passes the income and expenses to its shareholders who then report the income and expenses on their personal tax return.
A corporation owning a certain percentage of another companies stock can subtract a portion of that dividend income. Of course this is only if they have followed all the rules regarding how long they have held the stock and how much of the stock they actually own. There are somewhere between 3 and 5 different percentages of stock that qualify for the ‘Dividends Received Deduction’.
Reclassifying this as an expense – not retroactive of course, that would be a serious headache – would allow corporate books to be less complex, reduce the record keeping and tax preparation burden on corporations, would not discriminate against lower income individuals who might only own stock within a retirement plan in favor of higher income individuals who might tend to hold stock directly, and even give corporations a real incentive to pay dividends to their shareholders (case in point Microsoft has horded over $30 billion in cash)
Real tax reform must be sensible and make sense. This is only area of Federal Income taxation that I’m personally aware of where income is taxed twice. If you want to change it Mr Bush do it the right way.