Dividend Received Deduction

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The United States income tax law allows a Dividends Received Deduction for corporate shareholders who receive dividends from a domestic corporation. This deduction is permitted under §243(a) of the Internal Revenue Code (IRC).

The deduction amount depends on the percentage of ownership the receiving corporation possesses in the corporation distributing the dividends. If the corporate shareholder’s ownership percentage is less than twenty percent, the deduction percentage is limited to seventy percent of the dividend amount received. If the corporate shareholder’s ownership interest is between twenty and seventy-nine percent, the deduction percentage is limited to eighty percent of the dividend amount received. Lastly, if the corporate shareholder’s ownership percentage is equal to or greater than eighty percent, the deduction percentage allowed is one-hundred percent of the dividends received.

[edit] Purpose

The dividends received deduction reduces the inequity of triple taxation. Without the deduction, the same income would potentially be taxed three times. The first layer of taxation occurs when a corporation earns income. It is known that all corporate profits are taxed at graduated corporate rates. Furthermore, a second layer of taxation occurs when a corporation distributes those same earnings to its shareholders. Individual shareholders must recognize dividend income and pay tax at applicable individual rates.

The potential for a third layer of tax exists when a corporation pays dividends to a corporate shareholder. In this situation, the first corporation distributing the dividends is taxed on its earned income. Furthermore, the second corporation receiving the dividend distribution would pay tax on the dividend income collected. Lastly, a third tax is levied on dividends paid by the second corporation to its shareholders. However, to alleviate the burden of triple taxation, congress approved the dividends received deduction for corporate shareholders. Corporate shareholders can now significantly shrink and sometimes eliminate that tax paid on earned dividend income.

[edit] Limitations

The Taxable Income Limitation - The dividends received deduction is limited with regards to the corporate shareholder’s taxable income. Per §246(b) of the IRC, a corporation with the rights to a seventy percent dividends received deduction, can deduct the dividend amount only up to seventy percent of the corporation’s taxable income. Furthermore, a corporation with the rights to an eighty percent dividends received deduction can deduct the dividend amount only up to eighty percent of the corporation’s taxable income. However, no taxable income restriction is placed on a corporation with a one-hundred percent dividends received deduction.

For purposes of determining the appropriate dividends received deduction, a corporate shareholder’s taxable income should be computed without including net operating losses (NOL’s), capital loss carrybacks, and the dividends received deduction. However, the taxable income limitation does not apply to corporate shareholders who experience an NOL in the current taxable year.

The Holding Period Limitation – In order to receive the tax benefit of a dividends received deduction, a corporate shareholder must hold all shares of the distributing corporation’s stock for a period of more than 45 days. Per §246(c)(1)(A), a dividends received deduction is denied under §243 with respect to any share of stock that is held by the taxpayer for 45 days or less.

The complexity of this limitation is amplified per §246(c)(4). Section 246(c)(4) states that the stock’s holding period is reduced for any period in which the taxpayer has an option to sell, is under a contractual obligation to sell, or has made a short sale of substantially identical securities. In revenue ruling 94-28, the Internal Revenue Service (IRS) explains that the principle behind §243(c)(4) is to deny credit toward the 45-day holding period for any period during which the taxpayer is protected from the risk of loss inherent in the ownership of an equity interest.

Debt-financed Dividends Received Limitation – Code Section 246(A) disallows the benefit of the dividends received deduction for debt financed purchases of corporate portfolio stock. As stated by the Joint Committee on Taxation, the provision reduces the deduction for dividends received on debt-financed portfolio stock. Therefore, the dividends received deduction is available only with respect to dividends “attributable” to stock financed through other means besides debt. A simple ratio is computed to determine what percentage of an investment is debt-financed. As a result, the dividends received deduction is reduced by the percentage of the investment funded by debt.

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