What is the Dividends Received Deduction (DRD)?
The Dividends Received Deduction (DRD) is a beneficial federal tax deduction available in the United States for certain corporations receiving dividends from related entities. The extent of the DRD that a company can claim is contingent on the degree of ownership it has in the dividend-paying company. Specific criteria must be satisfied for corporations to be eligible for the DRD.
Key Takeaways
- Mitigates Triple Taxation: The DRD alleviates the cascading effect of triple taxation, benefiting certain corporations that receive dividends from other entities.
- Variable Deduction Percentages: DRD percentages range from a 50% deduction to a full 100% deduction, based on specified conditions.
- Qualification Rules: Several stringent rules must be followed for corporate shareholders to claim the DRD.
- Dividend Exclusions: Corporations cannot claim DRD on dividends from real estate investment trusts (REITs) or capital gain dividends from regulated investment companies.
- Domestic vs. Foreign: Different deduction rules apply for dividends from domestic and foreign corporations.
How Does the Dividends Received Deduction (DRD) Work?
The DRD enables a corporation receiving dividends from another corporation to adjust its taxable income by deducting the dividend amount, thus lowering its income tax. The amount of DRD a corporation can claim is contingent on the percentage of ownership it holds in the dividend-issuing company. For instance:
- A company owning less than 20% of the dividend-paying corporation can typically deduct 50% of the dividends received.
- Ownership of 20% or more allows for a 65% deduction of received dividends.
- Notably, the 50% or 65% limits do not apply if a corporation records a net operating loss (NOL) for the tax year.
The deductions effectively minimize triple taxation, which occurs when income is taxed at each stage: by the dividend-paying company, the receiving company, and finally through the shareholder when distributed dividends are received.
Additionally, small business investment companies (SBICs) can attract a 100% deduction on dividends received from taxable domestic corporations.
Special Considerations
Not all dividends qualify for the DRD. For example:
- Dividends from real estate investment trusts (REITs) are excluded from DRD eligibility.
- Dividends from companies exempt from taxation under section 501 or 521 of the Internal Revenue Code are not deductible.
- Capital gain dividends from a regulated investment company are also excluded.
Dividends received from foreign corporations feature distinct deduction regulations. Typically, corporations are allowed a 100% deduction of the foreign-source dividends from 10%-owned foreign corporations, provided the stock is held for at least 365 days.
Example of a Dividends Received Deduction (DRD)
Let’s illustrate with an example:
ABC Inc. owns a 60% stake in its affiliate, DEF Inc. For the tax year, ABC Inc. reports taxable income of $10,000 and receives a dividend of $9,000 from DEF Inc. Therefore, ABC Inc. qualifies for a DRD of $5,850, equivalent to 65% of $9,000.
Corporations must be mindful of existing limitations on the overall deductible sum for dividends. They may require calculating the DRD sans the 50% or 65% taxable income cap to determine if they have an NOL. For detailed guidelines, consult IRS Publication 542 or refer to instructions included in Form 1120, Schedule C.
Harnessing the DRD can significantly reduce corporate tax burdens and improve financial efficiency. Eligible corporations should judiciously apply the granular rules to fully optimize the dividends received deduction.
Related Terms: Triple Taxation, Net Operating Loss, Tax Cuts and Jobs Act, Small Business Investment Companies.
References
- Internal Revenue Service. “Publication 542, Corporations”. Page 10.
- Internal Revenue Service. “Publication 542, Corporations”. Page 11.
