Taxable Income

In contrast, corporations are separate legal entities that pay their own taxes by filing Form 1120 to report

all taxable income that has been earned4. However, when any dividends are eventually distributed from those

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earnings to the stockholders, this transfer is also viewed as taxable income to the owner. Income is taxed once

when earned by the corporation and again when distributed to the owners. Critics have long argued that the

collection of the dividend is not a new earning process. To mitigate the impact of this second tax, the United

States Congress has established a maximum tax rate of 15 percent on much of the dividend income collected by

individuals. This rate is considerably lower than that applied to most other types of income.

To illustrate, assume that income tax rates are 30 percent except for the 15 percent tax on dividends. A

proprietorship (or partnership) earns a profit of $100. In this type business, the $100 is only taxable to the owner

or owners when earned. Payment of the resulting $30 income tax ($100 × 30 percent) leaves $70. This is the

remaining disposal income. Any distribution of this money has no impact on taxes.

If a corporation reports this same amount of income, a tax of $30 is assessed to the business so that only $70

remains. This income can then be conveyed as a dividend. However, another tax must be paid, this time by the

stockholder. The second income tax is $10.50 ($70 × 15 percent). The owner is left with only $59.50 ($70.00 less

$10.50) in disposal income. The increase in the amount taken by the government ($40.50 versus $30.00 on $100

of taxable income) is significant enough to reduce the inclination of many owners to incorporate their businesses.

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