Those involved in the operation of a corporation must have a firm understanding of dividends, earnings and profits, and how corporations pay taxes. Essentially, a dividend is a distribution of a corporation’s money or property to a shareholder. Remember that legally, corporations are considered independent entities, so the money for dividends comes from the corporation’s resources and not the owners’.
Distributions that a corporation sends out are either considered a dividend, a sale, or an exchange of property. Each of these is taxed slightly differently, so it must be clear from the beginning which category a distribution falls into. Distributions are deducted from the corporation’s current earnings and profits. If the distribution exceeds the business’ current earnings and profits, it will then be deducted from the accumulated earnings and profits. If the distribution also exceeds the accumulated earnings and profits, the distribution is considered a sale or exchange of property. Otherwise, the distribution is considered a dividend.
Earnings and Profits
There is not a clear definition of earnings and profits. Essentially, earnings and profits are considered a business’s ability to pay dividends and other distributions without using the money contributed by creditors or the corporation’s shareholders. Earnings and profits are calculated as a company’s net profits after all dividends paid to shareholders are paid out. This includes gains, losses, deductions, and all items of income. Earnings and profits are determined starting at the date of the corporation’s creation or February 28, 1913, whichever is more recent. All economic activities of the business are taken into consideration.
Taxing on Dividends
Dividends are one of the most complicated aspects of a corporation from a tax standpoint. Dividends are typically taxed twice. Shareholders receiving the dividend must consider the distribution as income, regardless of whether they reinvest it in the corporation. As such, shareholders will include dividends on their taxes. This information is found in Schedule B of the shareholder’s tax return. Additionally, the corporation’s taxes, which are filed independently of any other individual’s, will also include the dividend. Shareholders must be given a Form 1099 Dividend each year which records all dividend information, which they will use for filing their taxes. While the shareholders’ dividend is taxed, if they reinvest it, it will also be considered a cost for stock and tax reasons. If a dividend is given to the owners, they will likely pay taxes on the dividend twice: once on the corporation taxes, and once on their own personal taxes.
If a distribution is considered a sale or exchange of property, taxation on the distribution is more complicated. In this case, shareholders will include the distribution on Schedule D of their return. Sometimes, dividends can be categorized as ordinary dividends if they are received from mutual funds. In this case, the dividends must be filed on Schedule B instead.
A-Type and S-Type Corporations
All the above information is regarding A-type corporations. When a corporation is established, it can either be created as an A-type or S-type corporation. Corporations are typically considered to be a completely separate legal entity. If the corporation is considered A-type, this extends to taxes as well. The corporation must file its own taxes, completely separate from the taxes of any shareholders or owners. It is most common for corporations to be A-type, although it is also possible to be an S-type corporation. In this case, the company owner has elected to have the corporation’s taxes filed as if it was a sole-proprietorship or partnership. If this is the case, the corporation’s taxes are combined with the owner’s or owners’ taxes. S-type corporations are usually only established for very small businesses. Regardless of the type of corporation, however, it is the responsibility of the owners to know how their taxes must be filed.
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