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The Effects of Debt Interest and Dividends on Taxes

written by: John Garger•edited by: Michele McDonough•updated: 9/25/2010

Debt interest paid to creditors and dividends paid to stockholders are treated differently from a tax perspective. This difference has a significant impact on the choices managers must make to finance a corporation.

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    Debt Interest and Dividends

    Corporations finance operations through two major methods. Debt is the borrowing of money to be paid back with interest over the life of the loan. Most corporate loans are in the form of bonds when the life of the debt will be longer than one year and notes when the life of the debt will be less than one year. Creditors who loan companies money are only owed what is stated in the terms of the loan, usually the principle plus interest. The second method used to raise capital is through the sale of stock or ownership in the company. This ownership, called equity, rises and falls in value dependent on the price of the stock selling in the marketplace. Corporations also typically share quarterly earnings with stockholders in the form of dividends paid on a per-share basis.

    Debt interest and dividends both represent regular payments to either creditors or stockholders and is part of the price of raising capital to finance corporate operations. However, the tax treatments of debt interest and dividends are different because of current tax laws. Interest paid to creditors for the borrowing of money is tax-deductible. In other words, interest is considered a cost of doing business just like the purchase of machinery, salaries paid to employees, and other contributions to overhead. However, dividends paid to stockholders are not tax deductible because they represent income as a reward for successful operations. The fact that the company decides to share these earnings with the owners of the company does not constitute a business expense but rather a redistribution of wealth.

    Earnings Before Interest and Taxes or EBIT (pronounced ee-bit) is a method of comparing both inter- and intra-company profitability without the penalty of financing or tax structure considerations. If a company is going to pay $100,000 in interest to a creditor, the company must have $100,000 in EBIT in reserve. If the firm is going to pay $100,000 in dividends to stockholders, the company needs more than $100,000 in reserve because taxes will be deducted from these earnings. In the case of interest, the full $100,000 is tax deductible so no taxes need be collected on the EBIT of that $100,000. In the case of dividends, the $100,000 is not tax deductible so taxes will be collected. Suppose that a corporation that is going to pay $100,000 in dividends has a tax rate of 45%. Taxes from the $100,000 of EBIT set aside for dividends will be taxed at $45,000 leaving only $55,000 for the dividend payout. The amount of EBIT needed to make the full $100,000 dividend payout can be calculated with the following formula:

    EBIT = d / (1 – t)

    Where EBIT is the Earnings Before Interest and Taxes needed to make the dividend payment, d is the total desired dividend payment, and t is the tax rate. Using the information above, the EBIT needed to pay $100,000 in dividends at a 45% tax rate is:

    EBIT = 100,000 / (1 – 0.45)

    = 100,000 / (0.55

    = $181,818.18

    So, approximately, $182,000 in EBIT is needed to pay the $100,000 dividend.

    This differentiation in taxes for interest and dividend payments is called asymmetric tax treatment. The result is an advantage to corporations who finance operations through debt rather than equity. Because dividend payments are not tax-deductible, equity financing increases the taxes paid by corporations who issue regular dividends. Given this information, it may seem foolish to ever pay a dividend. However, dividends offer incentives to investors to buy stock from a company that pays dividends than from one that does not, all things being equal. In addition, stopping the payment of dividends may have an adverse effect on the market’s perception of a firm’s profitability because of the signaling principle. Consequently, it may be more advantageous to the corporation to pay both the dividend and taxes than risk signaling that the company is not as profitable as it seems.

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