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A couple things you need to know about corporations and taxes — one intuitive, one not so intuitive. Let’s start with the one that’s not so intuitive.
Corporations don’t pay taxes.
That’s right, corporations don’t pay taxes. This has nothing to do with whether government imposes taxes, nor does it have anything to do with loopholes or tax evasion. Corporations don’t pay taxes because they can’t pay taxes. Only people pay taxes.
To argue that corporations should pay taxes is to argue the tooth fairy should pay taxes. Corporations are no more than legal fictions under which people organize and transact business. Any tax applied to a “corporation” is paid by a prime constituent: the owners, the employees, the customers. Apply a tax to a corporation and either the owners will pay with lower investment returns, the employees pay with lower compensation, or the customers pay with higher prices. Or all of the above will pay.
Taxes Reduce the Amount of Investment
As for the intuitive, corporate taxes reduce not only investment returns but the amount of investment that occurs. This is easy enough to understand if you understand that investments are valued based on the present value of after-tax cash flows. “After-tax” is the operative term.
Let’s consider a simple example: You own an investment that generates $100 in annual pretax cash flow. Apply a 35% corporate income tax rate (borne by the owners, employees, or customers, of course) to that $100 and the after-tax cash flow falls to $65.
Keep in mind, too, that every business investment has a minimum internal rate of return that must be met before the investment occurs.
For example, assume a one-year business project with an initial investment of $400 yields a $500 return. The business has a minimum internal rate of return of 25%. Is this $400 business project an investable project?
Yes, it is. This $400 investment generates enough return to meet the minimum internal rate of return ($100 divided by $400).
Now, let’s apply a 35% tax rate to our example. The $400 investment now yields $65 instead of $100. The return drops to 16.25%, which fails to meet the minimum return requirement. The investment never occurs; the cash flow that investment could have generated never occurs.
So, what does this pedantic finance lesson have to do with dividends? A lot, because taxes influence the dividends you receive.
Tax Holiday Could Deliver Dividend Bonanza
Last week, I explained that 10% tax holiday for repatriated offshore profits forwarded by President-Elect Donald Trump could lead to a dividend bonanza (read here). Nearly a trillion dollars could find its way into domestic corporate cash accounts.
If Trump’s repatriation tax holiday is enacted, I expect to see a surge in special dividends in 2017. If Trump’s plan to reduce the corporate income tax to 15% from 35% is enacted, I expect to see a surge in the amount paid as regular dividends.
I proffer this scenario because reducing corporate income tax rates is akin to reducing personal income tax rates: people, not corporations, pay tax. Trump’s plan to reduce the corporate income tax rate means more investments will generate a minimum internal rate of return. More investments generating a minimum internal rate of return means more cash flow.
I’m sure you follow the logic to its inevitable conclusion: More cash that flows into corporate coffers means more cash that will flow out as dividends.
A 10% tax on repatriated profits will lead to a surge in one-time special dividends. A 15% corporate income tax rate applied to all income ensures a higher stream of annual operating cash flow. If you’re inclined to view Trump’s plan to lower corporate income taxes as a handout to corporations, don’t, because it isn’t. Instead, view it as a plan to increase your dividend income.