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
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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