Although corporations enjoy four main advantages over other organizational forms, one disadvantage is double taxation. Since corporations are considered entities like a person, they may own property, enter into contracts, and take on debt. A corporation could enjoy an unlimited life assuming it is able to stay profitable.
One disadvantage of the corporate structure is double taxation. Since the corporation is considered an entity, it is taxed just like an individual. Then, the income of the corporation’s stockholders is taxed at the personal level when dividends are paid. This results in what is known as double taxation.
It is perfectly legal for one corporation to own part or all of another company. Just like individual investors, a corporation that owns another has the right to be paid dividends on the shares of stock owned in the other company. However, this creates a problem from a taxation point of view because it adds another level of taxation.
Current tax laws allow at least 70% of dividends received from another corporation to be free from taxation. In fact, depending on the percentage of ownership of the other company, this rate can be as high as 100% allowing the receipt of dividends to be completely tax free. The reason for the tax exemption has to do with multiple levels of taxation.
Under U.S. tax law, corporations are taxed as an entity and then dividends paid to the company’s owners are taxed at the personal level. This double taxation would turn into triple taxation if the corporation were taxed for dividends received. The first taxation would be levied when the original corporation is taxed for earnings. The second taxation would occur when the corporation that owns stock in the first corporation pays dividends for the shares of stock that represent ownership. The third taxation occurs when dividends are paid to the stockholders and is taxed as personal income.
Interestingly, interest paid to a corporation from another is fully taxed. Because of this, some corporations provide capital to another through the purchase of preferred stock. Preferred stock can be conceptualized to lie somewhere between debt such as a bond and ownership in the company such as buying common stock. Preferred stock holders are paid before common stock holders but after debt holders. This hybrid stock gives the buying firm priority over common stockholders like a debt holder but allows dividends received from ownership of the stock to be mostly, if not completely, free from taxation.
Monies paid to corporation as dividends face the possibility of triple taxation. Under current U.S. tax laws, between 70% and 100% of dividends paid to corporations through ownership of another company may be deducted from income to avoid this triple taxation. The result is higher capital gains and dividend payments to stockholders and higher profitability for the corporation.