FROM THE OFFICE OF PUBLIC AFFAIRS

• Under current law, income earned by a corporation is taxed at the corporate level, generally at the marginal rate of 35 percent.  If the corporation distributes earnings to shareholders in the form of dividends, the income is generally taxed again at the shareholder level (at rates as high as 38.6 percent). 

• In contrast, if a corporation retains earnings (instead of distributing them as dividends to shareholders), the value of corporate stock generally will increase to reflect the retained earnings.  When shareholders sell their stock, that additional value will be taxed in the form of capital gains (generally at a maximum rate of 20 percent).  Thus, current law is biased in favor of retained earnings and against dividends.

• The Administration’s proposal to exclude 100 percent of dividends from shareholder income requires a parallel tax adjustment for individuals to account for reinvested earnings of a corporation out of taxed earnings in order not to provide a bias against retained earnings.  A corporation has a legitimate business need to retain earnings for reasons such as new investment in plant and equipment.

• The Administration’s proposal would permit corporations that reinvest their taxed earnings to make an adjustment that would flow through to the shareholders’ stock basis reflecting the taxed income the corporation was retaining.  (Dividend reinvestment plans exist under current law for actual dividends paid.  Under current law, however, reinvested dividends are subject to a shareholder level tax even though a tax has been paid at the corporate level.)

• With this proposal, the decision by a corporation whether to retain earnings or distribute them in the form of excludable dividends would be more neutral.  The proposal would allow shareholders to increase their basis in the corporation’s stock by the amount of the retained earnings.

• A simple example will illustrate:

o Assume that a corporation, after being taxed on its profits at 35 percent, distributes excludable dividends to its shareholders.  Under the Administration’s proposal, no further tax is imposed although the value of its stock generally would decrease by the amount distributed.

o Assume that a different corporation, after being taxed on its profits at 35 percent, retains its earnings.  Also assume that the value of its stock would increase from $100 to $101 per share to reflect those retained earnings.  If a shareholder had purchased stock for $50 per share, without the adjustment for the retained earnings, the shareholder would pay tax on an additional $1 of gain ($101-50 = 51) when the stock was sold.  With the adjustment for retained earnings, the shareholder would increase basis to $51, thus eliminating the increase in gain ($101-51=50).  The decision to retain earnings by the corporation would not result in additional tax at the shareholder level.