Q:

Subject: Interest Income vs. Dividend Income

Kerry (Tax Guru),

My name is … I am currently a Doctoral student studying financial planning at Texas Tech University. I was searching for an answer to a question posed to me by one of my students and I stumbled upon your site. Funny enough I grew up in Harrison, Arkansas. Small world I guess. Anyways... I was talking in class last semester about the current tax cuts and there effect on the financial planning community. More specifically, how clients should diversify their tax retirement vehicles just as they would a portfolio.

One of my students posed the questions, "Why has the government cut rates on capital gains and dividends, yet did not reduced that tax rates on interest income (taxed as ordinary income)?" I suppose it has something to do with double taxation, but I am not an accountant nor an economist.

I was wondering do you have a short answer to this question or at least a sense of direction as to where I might look?

Thanks,

A:

I wasn't part of the discussions in Congress as to the different taxation on dividends versus interest; but I do have a theory to explain it. It has to do with both the concepts of the tax benefit rule and double taxation on C corporations.

Under the tax benefit rule, when one taxpayer deducts an expense, another taxpayer reports that same amount as income. It's a kind of balancing act. Interest is an example of this. Banks, businesses, and other payers of interest deduct it on their tax returns, thereby saving taxes at their ordinary income tax rates. The recipients of those interest payments then report them as ordinary income on their tax returns.

Dividends, on the other hand do not currently qualify as deductible expenses on the corporate tax returns. Since dividends are after tax dollars, this results in a second income tax on the same income.

While those of us who believe in capitalism would love to see a complete elimination of the double taxation through either a deduction on the corporate tax return or completely tax free on the stockholders' tax returns, that has never been politically feasible in this country, where hatred of evil corporations and rich people is stock in trade for politicians.

Over the decades, we have had some very minor offsets to the double taxation, usually designed to only assist the smaller investors. For example, there used to be an annual tax free exclusion of $100 in dividend income per person. This latest change, to tax dividends at the lower long term capital gains rates was explicitly designed as a mid-way compromise between those who believe there should be no double taxation at all and those who still want to stick it to corporations and their shareholders.

I hope this helps you understand some of the history behind the taxation of dividends.

Thanks for writing.

Kerry Kerstetter

Follow-Up:

Thank you so much,

Very Helpful!

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 6/09/2006 11:49:00 AM Send this post: