Are Dividends Really as Taxing as Firms Claim?

The theory bears out in the equity market as well. The 149 companies in the S&P 500 that do not pay a dividend saw their share prices plummet an average of 32.7% year-to-date as of Oct. 31. The 351 companies that do pay a dividend had an average drop in share price of just 12.6%. (There are other factors to consider, of course, but the difference is telling.)

Possible Solutions

There are two principal ways of eliminating this double taxation -- give the corporations a break or give the individuals a break.

The most popular corporate tax break proposed is to simply exempt from tax any profit that gets distributed to shareholders. A solution that gives companies an immediate tax break on the assumption that subsequent effects will benefit the individual, though, isn't politically viable on its own.

The core of any proposal will likely focus on the individual. The two options being floated in Congress now both allow for individual investor to exclude a portion of their dividends from tax. One way of accomplishing that is through a complicated calculation that would give individuals a tax credit based on the tax the corporation pays. Such a calculation is scalable, and would get larger in proportion to the size of the investment.

"The credit idea will die a quick death," predicts Martin Nissenbaum, the national director of income tax planning for Ernst & Young. "People won't understand how it works."

Alternatively, Congress can implement a more straightforward exemption; for instance, simply excluding the first $1,500 in dividends from tax. "The Internal Revenue Service just changed the rules for how dividends get reported," Nissenbaum says. "You don't need to fill out the Schedule B if you have $1,500 or less in dividends. That would be a good cutoff for the exemption."

All these possible solutions, though, will ultimately be evaluated based on how much they'll cost. As Congress debates a host of tax-policy changes -- including everything from expanding the benefits of retirement plans to eliminating the estate tax -- the benefits and cost of eliminating the double taxation of dividends must be weighed against each of the other tax policy proposals.

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