Which source of investor income is susceptible to double taxation?
A Interest earned
B Dividends
The correct answer and explanation is :
The correct answer is:
B. Dividends
Explanation:
Dividends are a form of income that shareholders receive from companies in which they own stock. These payments are typically made from the company’s profits. The reason dividends are susceptible to double taxation lies in the way both the corporation and the individual investor are taxed on the same earnings.
1. First Level of Taxation – Corporate Tax:
Corporations in the United States (and many other countries) are treated as separate legal entities. When a corporation earns profit, it must pay corporate income tax on those profits before any of the money can be distributed to shareholders. For example, if a corporation earns \$1 million in profit, it might pay 21% (the U.S. federal corporate tax rate) in taxes, leaving \$790,000.
2. Second Level of Taxation – Personal Income Tax:
After the corporation pays taxes, it may choose to distribute some of the remaining profits to shareholders in the form of dividends. When an investor receives these dividends, the amount received is considered taxable income, and the investor must pay personal income tax on it—usually at a rate of 0%, 15%, or 20% for qualified dividends depending on their income level, or at ordinary income rates for non-qualified dividends.
Example of Double Taxation:
- Company earns \$100 in profit.
- Pays \$21 in corporate taxes (21% rate).
- Distributes remaining \$79 as dividends.
- Investor receives \$79 and may pay up to \$15.80 (20% of \$79) in personal tax.
- Total taxes paid on the same \$100 profit = \$21 (corporate) + \$15.80 (personal) = \$36.80, or 36.8% effective total tax.
In contrast, interest earned (Option A) is not subject to double taxation. Interest is typically paid by banks, bonds, or other debt instruments and is only taxed once, as personal income to the investor.