Is corporate income double-taxed?
Yes, as a general rule. A corporation pays tax on its income, and its shareholders pay tax again when the income is distributed. But in practice, not all corporate income is taxed and many corporate shareholders are exempt from income tax.
Since 1909, corporate income has been subject to a federal tax (currently at a top rate of 35 percent). This income is generally taxed a second time when it is distributed as dividends that are liable to the individual income tax.
Suppose a corporation earns $1 million in profits this year and pays $350,000 in federal taxes. If the corporation distributes the remaining $650,000 to its shareholders, the distribution would be taxable to shareholders. Dividends are taxed at a top rate of 23.8 percent. As a result, only $495,300 would be left (assuming the dividends went to high-income individuals), and the combined tax rate on the income would be greater than 50 percent.
Some analysts consider this double-taxation inequitable. It discourages businesses from organizing as C corporations (which are subject to the corporate tax), encouraging them to be S corporations, partnerships, or sole proprietorships. Profits of an S corporation, partnership, or sole proprietorship are taxed only once (at a top rate of 43.4 percent), because the income is automatically passed through to the owners. By no coincidence, in recent years an increasing portion of businesses have been organized as pass-through entities (figure 1).
In some instances, corporations can reduce the double-taxation of their income. For example, a corporation may issue debt instead of stock to finance an investment and deduct the interest payments in the calculation of taxable income. Alternatively, a corporation can retain its earnings and not pay dividends. The corporation would still pay tax on its earnings, but the shareholders would defer the second round of taxation until the corporation distributed the earnings or the shareholders sold their stock at a price that reflected the value of the retained earnings.
But these choices distort business behavior. They encourage debt financing over equity, which creates a riskier capital structure for the corporation. And they encourage a corporation to retain earnings that might better be used by its shareholders.
In addition, there often is not a second level of tax. Many shareholders, such as retirement accounts, educational institutions, and religious organizations, are exempt from income tax; the earnings distributed to these shareholders are not double-taxed. By some recent estimates, the share of U.S. corporate stock held in taxable accounts has fallen from over 80 percent in 1965 to about 25 percent today (Rosenthal and Austin 2016).
Many other countries have “integrated” their corporate and shareholder taxes. Some countries permit corporations to deduct the dividends they pay to shareholders. Other countries give shareholders full or partial credit for taxes paid at the corporate level, or they permit shareholders to exclude dividends from their taxable income. There are pros and cons to each approach, but one thing is clear: integrating the two taxes would cost a lot of revenue.
Internal Revenue Service. Statistics of Income—Integrated Business Data. Table 1. “Number of Returns, Total Receipts, Business Receipts, Net Income (less deficit), Net Income, and Deficit. 1980–2012”
Rosenthal and Austin, The Dwindling Taxable Share of U.S. Corporate Stock, Tax Notes, May 16, 2016, p. 923
US Department of the Treasury. 1992. Report of the Treasury on Integration of the Individual and Corporate Tax Systems. Washington, DC: US Department of the Treasury.
White House and the Department of the Treasury. 2012. “The President’s Framework for Business Tax Reform.” Washington, DC: White House and the Department of the Treasury.