XYZ Corp., a domestic software company, holds a 15% ownership stake in Tech Innovations Corp. In the current year, the following applied to XYZ Corp.:
- Gross income: $1,000,000
- Expenses: $500,000
- Taxable income before DRD: $500,000
- Dividends received from Tech Innovations Corp.: $150,000
The DRD for XYZ Corp. will be calculated as follows:
- Step 1: $150,000 × 20% = $30,000 tentative DRD
- Step 2: $500,000 × 20% = $100,000 taxable income limitation
- Step 3: $500,000 − $30,000 = $470,000
- Step 4: No NOL created. DRD is limited to $30,000.
Conclusion
The Dividends Received Deduction is a valuable tax break for C corporations that receive dividends from other corporations in which they hold ownership stakes. By reducing the impact of triple taxation, the DRD helps protect corporate income from being subject to multiple layers of taxation. It is important for corporations to understand the ownership percentage requirements, holding period rules, and taxable income limitations that apply to the DRD in order to maximize their tax savings.
By following the guidelines and calculations outlined in this article, corporations can accurately compute their DRD and ensure compliance with IRS regulations. Consulting with a tax professional or financial advisor can also provide additional guidance and assistance in utilizing the DRD to its fullest potential.
One of the key provisions in the tax code that allows corporations to reduce their tax liability is the Dividends Received Deduction (DRD). The DRD is a tax deduction that allows corporations to exclude a percentage of dividends received from other corporations when calculating their taxable income. This deduction encourages corporations to invest in other corporations and promotes the flow of funds among businesses.
Calculating the DRD
When calculating the DRD, there are certain limitations and rules that corporations need to follow. Let’s take a look at two examples to understand how the DRD is calculated:
Example 1: DRD Calculation with Taxable Income Limitation
123 Corporation owns 70% of Small Corporation and has the following income and expense for the year:
- Gross income: $300,000
- Expenses: $275,000
- Taxable income before DRD: $25,000
- Dividends received from Small Corporation: $30,000
The DRD for 123 Corporation will be calculated as follows:
- Step 1: $30,000 × 65% = $19,500 tentative DRD
- Step 2: $25,000 × 65% = $16,250 taxable income limitation
- Step 3: $25,000 − $19,500 = $5,500
- Step 4: Since the taxable income limitation is less than the tentative deduction, the DRD is $16,250.
Example 2: DRD Calculation with Net Operating Loss (NOL) Created
X Corporation owns 70% of Y Corporation and has the following income and expense for the year:
- Gross Income: $250,000
- Expenses: $225,000
- Taxable income before DRD: $25,000
- Dividends received from Y Corporation: $50,000
The DRD for X Corporation will be calculated as follows:
- Step 1: $50,000 × 65% = $32,500 tentative DRD
- Step 2: $25,000 × 65% = $16,250 taxable income limitation
- Step 3: $25,000 − $32,500 = $7,500 NOL
- Step 4: Since an NOL is created, the taxable income limitation doesn’t apply, and the DRD is $32,500.
Dividend Types Excluded From the DRD
It’s important to note that there are certain types of dividends that are excluded from the DRD. These include dividends received from Real Estate Investment Trusts (REITs), Capital Gain Distributions from Regulated Investment Companies (RICs), and certain foreign corporations.
Common Pitfalls in Claiming DRD
Failing the Holding Period Requirements
Corporations may fail the holding period requirement for various reasons, such as including the day of purchase in the holding period and not considering wash sale holding periods when calculating the required holding period.
Deducting Dividends with Debt Characteristics
For the DRD to apply, the dividend must not be subject to attachment by a creditor. Preferred stock dividends may qualify for the DRD, but the DRD may not apply when the preferred stock has debt characteristics.
Missing the DRD for Foreign Dividends
While most foreign dividends do not result in a DRD, there are exceptions to this rule. It’s essential for corporations to understand the specific rules and limitations when it comes to claiming the DRD for foreign dividends.
By understanding the rules and limitations of the Dividends Received Deduction, corporations can effectively reduce their tax liability and optimize their financial planning strategies.
The Dividend Received Deduction (DRD) allows domestic C-corps to deduct a portion of dividends received from another corporation in which they have an ownership interest. However, when it comes to dividends paid from foreign corporations with both domestic and foreign sources, the deduction is only allowed for the part of the dividends from US sources.
For more detailed information on the DRD for foreign dividends, you can refer to the IRS’s Dividend Received Deduction Overview concerning foreign entities.
### Frequently Asked Questions (FAQs)
#### When is the percentage rate 70% for the dividend received deduction?
The 70% percentage rate is no longer applicable for years after December 31, 2017. The current rates are 50%, 65%, or 100%.
#### Can the dividend received deduction be carried forward to future tax years?
No. The dividend received deduction is a use-it-or-lose-it tax deduction. Any unused amounts are not carried forward to future years.
#### Can S-corps take advantage of the dividends received deduction?
No, the DRD is only available to domestic C-corps and is limited to the investor’s taxable income for the period.
#### What types of dividends are eligible for the dividends received deduction?
Both common and preferred stock dividends are eligible for the DRD.
#### How does a small business investment company claim the 100% dividends received deduction?
A small business investment company can claim the special 100% DRD by attaching a statement to the business’s income tax return stating that at the time of dividend receipt, the company was a “federal licensee” under the Small Business Investment Act of 1958.
### Bottom Line
In conclusion, the DRD provides a valuable opportunity for domestic C-corps to reduce their tax liability on dividends received from other corporations. By understanding the rules and regulations surrounding the deduction, companies can make informed decisions to optimize their tax obligations.