What is the Dividends Received Deduction?
By: Ned Piplovic,
The dividends received deduction (DRD) is a specific tax write-off under the U.S. federal tax code that allows certain corporations to deduct from their taxable income a portion or all received dividends from other business entities in which the corporation has an ownership stake.
While tracking and filing the received dividends deduction can get complex, the concept is fairly straightforward. The main purpose of the received dividends deduction is to prevent potential triple taxation of certain dividend distributions.
However, before digging deeper into the intricacies of the dividends received deduction, let us discuss a few dividend basics.
What are Dividends?
Dividends are just distributions of a company’s assets or earnings to shareholders. Depending on the source of the payout — earnings, assets, interest, etc. — a dividend might technically be called a “distribution.”
Formally, dividends are earnings disbursement and generally apply to distributions from C-corporations, real estate investment trusts (REITs) or similar business entities. Conversely, S-Corporations, master limited partnerships (MLPs), limited liability companies (LLCs), trusts and estates technically pay “distributions”. Additionally, money market funds, certificates of deposit (CDs), bonds and exchange-traded debt securities pay interest.
However, since the dividends received deduction applies only to C-corporations, we will not discuss distributions in this article. Furthermore, many investors — especially novices and part-time investors — use the term “dividend” interchangeably as a universal designation for all types of payments.
Dividend Income Types
The most frequent type of dividend income distributions are cash payouts. Cash dividends are easy to distribute for the equity making the payouts and easy to manage for the investors receiving the income. However, sometimes equities will distribute in-kind dividends, which might include stock dividends, property dividends, bonds of the company distributing dividends, bonds of a different corporation, government bonds, accounts receivables and promissory notes. In addition to the apparent differences between the dividend types, different types of dividend payouts are treated differently for taxation purposes. Ordinary dividends incur taxation at ordinary income rates and qualified dividends enjoy the befit of taxation at lower, capital gains rates.
Taxation of Dividend Income
The Internal Revenue Service (IRS) treats stock dividends as stock splits for taxation purposes. Therefore, any stock dividend transfer between companies is not subject to taxation at ordinary income rates. Furthermore, even at the time of sale, those shares are taxed at capital gains rates, which generally are lower than ordinary income tax rates applicable to many cash dividends.
Even investors that are not tax experts can differentiate the tax liability impact by the location of the dividend amount reported on the IRS 1099-DIV Form. Generally, the total amount of ordinary dividends will be listed in the 1a box at the top of the form. Alternatively, the amount of qualified dividend taxable at capital gains rates will appear in box 1b of the same form.
The tax rates for ordinary income are subject to ordinary income tax rates and brackets.
The Tax Cuts and Jobs Act (TCJA) passed by Congress on December 22, 2017, revised the tax bracket structure for qualified dividends. The table below presents the rates and applicable income limits for qualified dividends.
Dividends Received Deduction
While containing some complexity, dividend taxation for individual investors and basic business entities is fairly straight forward. However, complex C-corporations with multiple wholly-owned subsidiaries could end up paying income taxes multiple times on the same income transferred between various corporate entities.
Therefore, the current tax code has the dividends received deduction exemption, to alleviate taxing the same income multiple times. This multiple taxation can occur when a corporate entity distributes dividends to its parent company or another C-corporation that has an ownership stake.
The first level of taxation occurs when the company distributing the dividend pays taxes on its earnings before distributing dividends. Subsequently, the company receiving the dividend income is responsible for paying taxes on that income. Lastly, a portion of the original dividend income is subject to taxation for the third time when the shareholders of the second company receive dividend distributions, which become taxable income for the individual shareholders.
Dividends Received Deduction to the Rescue
To avoid some of the triple taxation of dividend distributions, the Internal Revenue Code (IRC) allows for three levels of dividends received deduction. However, the code also specifies additional requirements that corporations must meet to claim eligibility for the dividends received deduction.
Depending on the type of corporate entity, the specific eligibility requirements can get rather complex in a hurry. The complexity grows exponentially when dealing with particular types of dividends, such as dividends distributed by foreign corporations, dividends from Small Business Administration (SBA) corporations or preferred stock dividends distributed by utility companies.
For simplicity, the focus here will be only on the dividends distributed by domestic corporations that are not subject to any of these additional rules and requirements. Chapter 243 of the Internal Revenue Code — U.S. Code Title 26, Subtitle A, Chapter 1, Subchapter B, Part VIII, Section 243 — contains the basic dividends received deduction rules.
To qualify for the dividends received deduction, a company must meet three basic requirements:
- The company taking the deduction must be structured as a C-corporation.
- The corporation must be a domestic corporation, which is defined as “…created or organized in the United States or under the law of the United States or of any State…” Please note that a foreign corporation could be eligible to take the dividends received deduction under certain circumstances. However, that is a subject for another occasion.
- The corporation making the initial dividend distribution must be a taxable entity. The Internal Revenue Code does not allow the dividends received deduction for dividends received from corporations that have tax-exempt status outlined in Sections 501 or 521.
Domestic C-corporations that meet the basic requirements listed above can claim one of three levels of the dividends received deduction based on the ownership stake in the corporate entity distributing the dividend.
C-corporations with less than 20% ownership stake in the corporate entity distributing the dividend can deduct 70% of the received dividends for income tax calculations. Conversely, the company receiving the dividend must report only 30% of the received distributions as taxable income.
C-corporations with 20% or more ownership, but less than 80% ownership stake can deduct 80% of dividend income received — report 20% of received dividends as taxable income.
C-corporations with 80% or more ownership can deduct the full amount of dividend received and have no income tax liability on that portion of their income.
An additional restriction on the dividends received deduction is the minimum holding period requirement. The corporate stock owner must hold the shares for at least 45 consecutive days before claiming the dividends received deduction. Additionally, this 45-day time frame can not include any period during which the stock-holding corporation had a right or option to sell the shares at a fixed price. The intent of this requirement is to make the benefits of the dividends received deduction available only to corporations with exposure to the risks associated with stock ownership.
This basic outline should provide sufficient information for a basic understanding of the dividends received deduction. As always, taxation and tax deductions can be very complex and investors should always seek additional help from professional investment advisors and tax experts.
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