Dividend Exclusion: What It Is and How It Works for Corporations

What Is Dividend Exclusion?

Dividend exclusion is a general term for a variety of federal and state tax provisions that allow corporations to exclude from their taxable income a portion of the dividends they receive from other corporations. The purpose of excluding these received dividends is to shield them from double taxation or even triple taxation. Under current U.S. tax law, corporations are able to exclude all or part of their received dividends through the dividends-received deduction (DRD).

What Is Double or Triple Taxation?

Double taxation occurs when the same income is taxed twice. Triple taxation is when it is taxed three times. For example, a corporation is required to pay taxes on its profits. When it distributes a portion of its profits to its shareholders in the form of dividends, the shareholders must pay tax on those dividends. That is double taxation.

Now suppose a corporation owns stock in another corporation. The first corporation pays a tax on its profits, some of which it passes along to the second corporation as a dividend. The second corporation must then pay tax on its profits (some of which may represent the dividends it received from the first corporation). If the second corporation pays out a dividend to its shareholders, they will be taxed on that income—in effect, taxing the same income a third time. The dividends-received deduction provides corporations with a way to avoid taxation on at least some of the income they receive from other corporations.

How the Dividends-Received Deduction Works

The dividends-received deduction allows corporations to deduct a portion of the income they received from their ownership interests in other corporations when they file their corporate income taxes for the year.

How much they can deduct depends on their relationship to the other corporation:

• Dividends from foreign corporations. A corporation is allowed to deduct as much as 100% of the dividend income it receives from certain foreign corporations, defined as qualified 10-percent-owned foreign corporations, subject to the rules spelled out in the instructions for IRS Form 1120: U.S. Corporation Income Tax Return.
  
• Dividends from U.S. corporations. Dividends that a corporation receives from another domestic corporation are partially deductible. Specifically, corporations can deduct 50% of the dividends they receive if they own less than 20% of the stock of the corporation distributing the dividend. If they own 20% or more of the distributing corporation's stock, they can deduct 65% of the dividends received. Both of these amounts are subject to certain limitations, also spelled out in the 1120 tax form instructions.

In addition, corporations may deduct 100% of dividends received from another corporation that is part of the same affiliated group.

Dividend Deductions and the Tax Cuts and Jobs Act

The federal Tax Cuts and Jobs Act (TCJA) passed in late 2017 changed the rules on how much of its received dividends a corporation could deduct, lowering the applicable amounts starting on Jan. 1, 2018. Until that point, corporations that owned less than 20% of another company's shares were able to deduct 70% of their received dividends. If a corporation owned 20% or more of the company, it could deduct 75% of the dividends. (As noted above, those numbers are now 50% and 65%, respectively.)

The new tax law also replaced the graduated corporate tax rate scheme, which had a top rate of 35%, with a flat 21% tax rate on all C corporations. Factoring that in, the reduced exclusions and the lower tax rate were expected to result in roughly the same actual tax due on dividends received.

Benefits of Dividend Deductions

By deducting the dividends paid out to shareholders, corporations can lower their taxable income which can lead to tax savings. This not only improves the company's net income but also allows it to reinvest more resources into growth and expansion initiatives. The company may then receive more favorable debt financing terms if its profitability margins look favorable (due to having less of a tax expense burden).

Offering dividends can also make a corporation's stock more attractive to a broad range of investors, thereby potentially increasing the demand and stability of the stock with fewer negative impacts to consider. A stable shareholder base, in turn, can lead to reduced stock price volatility and a more predictable market performance for the corporation.

Being able to deduct dividends not only preserves more of the company's earnings but also enhances its cash flow. With more cash on hand, corporations have greater flexibility to fund operations, pursue growth opportunities, or return value to shareholders through additional dividends or share buybacks.

The Bottom Line

Corporations are allowed to deduct a portion of the dividend income they receive before they pass it along to their own shareholders. Individual shareholders, however, continue to be taxed on the dividends that they receive.