What You Need to Know About the Dividends Received Deduction

The dividends received deduction is a tax benefit that can significantly reduce a company's tax liability. It allows corporations to exclude a portion of the dividends they receive from their taxable income.

To qualify for the dividends received deduction, the dividend-paying corporation must be a domestic corporation. This means it must be incorporated in the United States and its income must be subject to U.S. taxation.

The deduction is based on the percentage of the corporation's stock that is owned by other corporations. This is known as the "qualified corporate shareholder" requirement.

Take a look at this: Blocker Corporation

To be eligible for the dividends received deduction, your corporation must have the rights to a certain percentage of the dividend, which can range from 50% to 100%. A corporation with a net operating loss for the year is exempt from income limitations.

The taxable income limitation is another factor to consider. A corporation with a 70% or 80% dividends received deduction can only deduct the dividend amount up to 70% or 80% of its taxable income, respectively. However, if the corporation has a net operating loss, the limitation does not apply.

If your company owns less than 20% of the paying company, the limit is even lower, at 50% of your company's taxable income. But if allowing the full 50% deduction would cause or increase a net operating loss deduction, the limit doesn't apply.

Worth a look: The Payout Ratio Equals Cash Dividends Divided by Net Income.

The dividends received deduction has some limitations, particularly when it comes to debt financing. Code Section 246A disallows the benefit of the DRD for debt-financed purchases of corporate portfolio stock.

This means that if you've used debt to finance your investment in a corporation, you can't fully deduct the dividends you receive from that investment. The Joint Committee on Taxation explains that this provision reduces the deduction for dividends received on debt-financed portfolio stock.

To determine the amount you can deduct, a simple ratio is computed to determine what percentage of your investment is debt-financed. This percentage is then used to reduce the dividends received deduction.

Here's a breakdown of how the debt-financed limitation works:

The debt-financed limitation can be a significant factor in determining the amount you can deduct, so it's essential to understand how it works.

The ownership level of the payor's stock has a significant impact on the dividends received deduction. If your company owns less than 20% of the paying company, you can deduct up to 50% of the dividend received.

Take a look at this: What Does Received Mean on Snapchat?

This means that the more you own of the company paying the dividend, the more you can deduct. The tiers are as follows:

For example, if Company A owns 10% of Company B, it can deduct up to 50% of the dividend received from Company B.

The income limitations of the dividends received deduction (DRD) can be a bit tricky to navigate. If a corporation has a net operating loss for the year, these income limitations do not apply.

The DRD cannot exceed the corporation's taxable income. For example, to take a 50% deduction on a qualifying dividend, this deduction amount cannot exceed 50% of the corporation's taxable income.

If a corporation has a net operating loss for the year, these income limitations don't matter. This is a significant exception to the rule, allowing corporations with NOLs to deduct a larger portion of their dividend income.

A corporation's taxable income is the key to determining how much of the DRD they can claim. This includes all income, minus any deductions and exemptions.

In some cases, the income limitation is tied to the corporate shareholder's taxable income, not the corporation's. This is a bit more complicated, but essentially, the corporation can only deduct up to a certain percentage of their taxable income.

Take a look at this: Taxes on Sale of Business S Corp

To receive a tax benefit from a dividends received deduction, you must hold the stock for more than 45 days. This is a strict requirement.

The IRS is very clear about this, stating that a dividends received deduction is denied if you hold the stock for 45 days or less. This is outlined in §246(c)(1)(A).

Any period where you have an option to sell, are under a contractual obligation to sell, or have made a short sale of similar securities reduces your holding period. This is according to §246(c)(4).

The IRS explains in revenue ruling 94-28 that this principle is to deny credit for any period where you're protected from the risk of loss inherent in owning an equity interest. This is to ensure you're truly invested in the stock.

The taxable income limitation is an important factor to consider when calculating the dividends received deduction. This limitation restricts the amount of deduction that can be taken based on the corporation's taxable income.

You might enjoy: Unrelated Business Income Tax

For example, if a corporation has a 50% dividends received deduction, this deduction amount cannot exceed 50% of the corporation's taxable income. However, if the corporation has a net operating loss for the year, these income limitations do not apply.

A corporation with a 70% dividends received deduction can deduct the dividend amount only up to 70% of the corporation's taxable income, while a corporation with an 80% dividends received deduction can deduct up to 80%. There are two exceptions to this taxable income limitation: corporations with a 100% dividends received deduction are not subject to this limitation, and if the dividends received deduction increases or creates a net operating loss, the limitation does not apply.

Here's a summary of the taxable income limitation for different dividends received deductions:

It's worth noting that if allowing the full 50% dividends-received deduction without regard to taxable income would cause (or increase) a net operating loss deduction for the year, the limit does not apply.

Broaden your view: Tax Deduction

The dividends received deduction is a valuable tax break that can help reduce your tax liability. A large technology company can take a dividends received deduction of $650 million on a $1 billion dividend income, thanks to its 50% joint venture interest in another company.

The ownership level plays a significant role in determining the deduction amount. For example, a conglomerate with a 50% stake in an oil company can deduct 50% of the dividends received, which is $500 million in this case.

In contrast, a conglomerate with an 85% stake in a REIT cannot deduct any of the dividend income received. This highlights the importance of understanding the ownership structure when it comes to the dividends received deduction.

Here's a summary of the deduction amounts based on the ownership level:

Keep in mind that the specific rules and regulations surrounding the dividends received deduction can be complex, so it's essential to consult with a tax professional to ensure you're taking advantage of this tax break correctly.

The dividends received deduction (DRD) is a game-changer for corporations when it comes to tax time.

This deduction allows corporations to avoid triple taxation on dividend income they receive from a related entity.

The DRD comes in tiers, which means the deduction amount is not a straightforward 100%.

To qualify for the DRD, the company paying the dividend must meet certain qualifications.

The DRD can be a huge relief for corporations, preventing them from being taxed on dividend income twice.

A fresh viewpoint: Realty Income Preferred Stock Dividend

The dividends received deduction (DRD) helps alleviate the triple taxation scenario, where a company is taxed three times on the same income.

This occurs when a subsidiary corporation pays tax on its income, the parent corporation pays tax on the dividends received from the subsidiary, and the shareholders are taxed on the dividends they receive from the parent corporation.

By allowing for a reduction in taxes paid by the parent corporation, the DRD helps alleviate this triple taxation scenario.

See what others are reading: Realty Income Corporation Dividend

The DRD allows corporations to deduct as much as 100% of the dividend income they receive from a related entity on their taxes, preventing the potential for triple taxation.

The DRD comes in tiers and the company paying the dividend must meet certain qualifications for the receiver to use the DRD.

The DRD is limited to a certain percentage of income, but the limit doesn't apply if allowing the full 50% dividends-received deduction would cause a net operating loss deduction for the year.

Varian operates through corporations in many different countries, including controlled foreign corporations (CFCs) as defined in section 957(a). Varian and its CFCs are fiscal year taxpayers, meaning their taxable years do not end on December 31.

The fiscal year of Varian and its CFCs started on September 30, 2017, and ended on September 28, 2018 (2018 Year). Varian filed a consolidated federal income tax return for the 2018 Year and claimed foreign tax credits for foreign taxes deemed paid under section 960.

Suggestion: Internal Revenue Code Section 79

Varian elected to claim foreign tax credits for foreign taxes deemed paid under section 960 and was therefore required to "gross up" its taxable income under section 78. The Commissioner examined Varian's tax return and issued a Notice of Deficiency, disallowing Varian's claimed deduction under section 245A.

The dividends-received deduction complements the consolidated return regulations, which allow affiliated corporations to file a single consolidated return for U.S. federal income tax purposes. This deduction is designed to reduce the consequences of alleged triple taxation, which would occur when a company pays taxes on income, the company receiving the dividend pays taxes on the payment, and the company receiving the dividend makes a dividend payment to its shareholders, who pay dividend taxes.

The dividends-received deduction helps alleviate the potential burden of triple taxation of the income used to pay dividends to the ultimate shareholders. The deduction enables the company receiving the dividend to shield as much as 100% of that income from taxes, reducing the potential impact of triple taxation.

The Commissioner determined that if Varian was entitled to deduct its section 78 dividend under section 245A, then section 245A(d) would disallow any foreign tax credits attributable to that amount. This would reduce Varian's foreign tax credits by approximately $6,362,356.

Additional reading: Solo 401k for S Corp

The dividends-received deduction is designed to reduce the consequences of alleged triple taxation. This means that corporate profits would be taxed to the corporation that earned them, then to the corporate shareholder, and then to the individual shareholder, which is not what Congress intended.

The consolidated return regulations help alleviate this issue by allowing affiliated corporations to file a single consolidated return for U.S. federal income tax purposes. This makes it easier for companies to manage their taxes and avoid the triple taxation issue.

The dividends-received deduction complements the consolidated return regulations by enabling the company receiving the dividend to shield as much as 100% of that income from taxes. This helps alleviate the potential burden of triple taxation of the income used to pay dividends to the ultimate shareholders.

Here's a breakdown of how ownership level impacts the dividends-received deduction:

Varian operates through corporations in many different countries, at least some of which are controlled foreign corporations (CFCs).

Varian and its CFCs are fiscal year taxpayers, meaning their taxable years don't end on December 31.

Varian filed a consolidated federal income tax return for the 2018 Year, electing to claim foreign tax credits for foreign taxes deemed paid under section 960.

The return included a "gross up" of taxable income under section 78, reporting a dividend of approximately $159 million.

Varian also claimed a deduction of approximately $60 million under section 245A in connection with the dividend.

The Commissioner examined Varian's tax return and issued a Notice of Deficiency, disallowing the claimed deduction under section 245A.

The Commissioner increased Varian's section 78 dividend by nearly $1.9 million and determined that foreign tax credits would be reduced by approximately $6,362,356 if the deduction was allowed.

Related reading: Do S Corps Pay Corporate Taxes