It is very likely illogical to assume that a tax code as crazy and screwed up as the Internal Revenue Code (IRC) would take just one bite at the apple. And in this, the season of All Hallows’ Eve, when witches stir and ghosts and goblins are afoot, we do learn that the IRC repeatedly cuts in line when bobbing for apples. One bite is not nearly enough.
Shakespeare had an apt expression in The Tragedy of Macbeth, “Double, Double, toil and trouble…”
Many American taxpayers are familiar with the oft voiced complaint regarding the double taxation of dividends paid to corporate shareholders. Would that this was the only circumstance for which bemused authors of our tax code stand around the cauldron repeatedly casting spells and curses on unknowing and unsuspecting taxpayers.
Hardened criminals, guilty of the worst felonies are protected from double jeopardy by the Fifth Amendment to the Constitution which states in part, “…nor shall any person be subject for the same offence to be twice put in jeopardy of life or limb…” I guess if the offense is that of earning a living, twice placing earned income under the burden of taxation is fair game.
Let’s examine corporate dividends and satisfy ourselves that corporate income is actually subject to double taxation or if we are seeing double.
First, all U.S Corporations (foreign corporations must pay tax on income earned inside the United States), other than those established and approved as tax exempt under Section 501 of the IRC, are subject to income tax on their worldwide taxable income. Income tax assessed on corporate income is spelled out U.S. Code › Title 26 › Subtitle A › Chapter 1 › Subchapter A › Part II. › Tax on Corporations. (The tax assessed on individuals is detailed in Part I.)
All of the legalese and mumbo-jumbo written in this section of the IRC can be summarized from the language contained in §11, Paragraph (a) “A tax is hereby imposed for each taxable year on the taxable income of every corporation.” In plain English, if a company makes money, it has to pay income tax on that money, forgetting for the moment, all of the various credits, deductions and offsets that serve to reduce the amount of tax actually paid.
This begs the question, what does a company do with the income left after taxes? That question can have several answers. But one possible action is that the company distributes some, or part of that amount to the owners of the company. After all, the main reason people start and grow a company is to make money. But what happens under our tax system if that income is distributed to the owners?
Those cash payments are yet again considered as income. But this time it is held to be income to the owners (i.e. recipients). The payment is typically reported to the recipient and to the IRS on Form 1099-DIV. The language governing dividend payments is somewhat more involved than the earlier example. However, the relevant wording is excerpted below:
Except as otherwise provided in this chapter, a distribution of property made by a corporation to a shareholder with respect to its stock shall be treated in the manner provided…the amount of any distribution shall be the amount of money received, plus…Amount taxable…In the case of a distribution…That portion of the distribution which is a dividend shall be included in gross income…the term “dividend” means any distribution of property made by a corporation to its shareholders…out of its earnings and profits…
Translated, this language defines dividends as money taken from corporate profits and paid by the corporation to its owners. The IRC mandates inclusion of this amount in gross income. The same dollar earned by a corporation, on which tax was paid, is taxed once more when distributed to the owner(s) of that corporation.
Voila! Double taxation!
I will not delve into all of the variations, permutations, exceptions, contradictions and conflicts in the tax code that may make some of this income non-taxable either to the company or the owner. Bottom line, our tax code sets up a structure under which this income is subject to double taxation.
If this situation troubles you, then I should quote an advertising line frequently used in late night TV infomercials. “Wait, there’s more!”
The multi-layered labyrinth we have created with our federal and state tax structure make much, if not all income subject to double taxation.
Earn a significant level of income and elect to give some of it away, not to charities, for which you can deduct the donation, but to family and friends. Not considering the lifetime exclusions or other exceptions, this amount is subject to a gift tax. You guessed it! Double taxed!
Most of us pay for the things we purchase out of our income. Often that amount is referred to as net income, or take-home pay. Why? Because we have already had taxes withheld (i.e.“paid”) from that income. What happens when we buy something? Frequently we are compelled to pay a sales tax. Once again, double taxation. (Author's note - Yes, I strayed as this tax is not mandated by the IRC.)
This list of examples goes on. But let’s return to the IRC and examine one of the largest examples of double taxation. While dividends may not be taxed for one or another reason, either when reported as corporate income or distributed as a dividend, the following example does not permit any exceptions from taxation whatsoever.
The IRS defines earned income as “…all the taxable income and wages you get from working or from certain disability payments.” The IRS suggests that there are two ways to get earned income.
(1) You work for someone who pays you;
(2) You own or run a business or farm.
We all understand that earned income must be included in reported gross income for income tax purposes. But we often overlook the fact that this income is subject to a second tax (Author’s note – FICA for those who are employed and SECA for those who own a business.) Tax purists may say, "yes, the income is taxed twice, but it is a different tax." I say "Bah! Humbug!" Remember my post using the duck analogy? Maybe we will now properly consider this tax as double taxation.
Assume an employee earns $50,000 a year. The employee pays 7.65% social security tax on the amount earned. In other words, the full amount is subject to social security tax. The tax amount is not given to the employee but paid to the IRS, thus the employee actually receives only $46,175. But, on April 15 of the following year, this individual must report the full amount, $50,000, as earned income, and then pay income tax on that full amount. Bottom line, the employee pays payroll tax on the full wage of $50,000 and then pays income tax on the same amount. If that is not double taxation, the tool in the shed is much duller than I originally thought.
To make this situation even worse, I could perhaps describe this methodology by saying that most working Americans pay income tax on the social security tax they paid to the IRS. In a later post I will jump from the firing pan into the fire and address the income tax applied to social security payments. Retirees pay income tax on the money they paid into the social security system, on which they paid income tax at that time. Damn!
By enacting the tax code as it now exists, Congress has said, “Let’s play Double Jeopardy!” For taxpayers who try to double up, Congress has an answer. It is time to double down.
Well I say it is time to fix our SNAFU tax code!
With respect to dividend income, Congress has attempted, perhaps correctly and fairly although ineffectively, to amend the IRC to avoid taxing the same income twice. For small corporations, Congress has established a separate corporate structure for tax purposes. This type of company is often simply called an “S” corporation and is described under U.S. Code › Title 26 › Subtitle A › Chapter 1 › Subchapter S › Tax Treatment of S Corporations and Their Shareholders. Under this structure, the net income of a company passes directly to its shareholders thereby avoiding double taxation of the profit.
While this methodology creates a different set of problems, it does mitigate double taxation of dividends.
However, to my knowledge, the onerous burden of double taxation created by our payroll tax system has never been addressed. Relief from other forms of double taxation is provided in our tax code. The IRC allows a deduction from taxable income for state income or sales taxes and property taxes. Not so with payroll taxes.
I recognize that asking Congress to fix something that it broke in the first place may be taking a very big risk. I am reminded of the poet David Keppel, who wrote:
Better never trouble Trouble
Until Trouble troubles you;
For you only make your trouble
Double-trouble when you do…
Enough double talk. I have to wrap this up and head to the neighborhood pub. I think I will ask the bartender to “make mine a double!”
I'll catch you around. I’m outa here!