Palomino Enterprises has generated profits of $300 000 before tax. They wish to invest the money in Treasury bonds at 8% and use the returns to pay dividends to shareholders after a year. Alternately, they can pay a dividend and allow shareholders to make the investment. If corporate tax rates are 30%, which option would be preferred by shareholders paying a marginal tax rate of 45%?

Question

Quizplus · Accepted Answer

If Palomino Enterprises invests the $300,000 at 8%, the investment will grow to $324,000 before tax. After corporate tax (30%), the amount is $226,800. Shareholders then receive this as a dividend, and after their personal tax (45%), they receive $124,740. If the company pays the dividend immediately, the $300,000 is reduced by the shareholders' tax rate (45%), leaving them with $165,000. Thus, waiting for the dividend after the investment grows and is taxed is more beneficial for shareholders despite the double taxation, because the initial investment amount is higher before any taxes are applied.

Palomino Enterprises Has Generated Profits of $300 000 Before Tax