There’s a valuable tax deduction available to a C corporation when it receives dividends. The “dividends-received deduction” is meant to reduce or get rid of an extra tax that a corporation has to pay when it gets dividends. As a result, a corporation will pay less tax on dividends than on capital gains.
Most of the time, the deduction is equal to 50 percent of the dividend. This means that only 50 percent of the dividend is actually taxed. For example, if your corporation receives a $1,000 dividend, it counts that as income. However, after the $500 dividends-received deduction, the dividend only counts as $500 in taxable income.
If your company owns 20 percent or more (by vote and value) of the payor’s stock, the amount of a dividend that can be deducted goes up to 65 percent of the dividend. If the payor is part of an affiliated group (based on an ownership test of 80 percent), dividends from another member of the group are completely tax-deductible.
If one or more members of the group have to pay taxes in a foreign country, a special rule says that all foreign taxes must be treated the same way. For the 20 percent and 80 percent ownership percentages, preferred stock isn’t counted if it’s limited and preferred in terms of dividends, doesn’t contribute much to the company’s growth, can’t be converted, and has limited rights to be redeemed or liquidated.
If a dividend on a stock that hasn’t been owned for more than two years is an “extraordinary dividend,” the amount that doesn’t get taxed because of the dividends-received deduction is subtracted from the stock’s “basis.” If the reduction is more than the stock’s basis, a gain is recognized. (A dividend paid on common stock is considered an extraordinary dividend if it is more than 10% of the stock’s basis. Dividends with ex-dividend dates within the same 85-day period are treated as a single dividend.)
Holding period for dividends-received deduction
The dividends-received deduction is only available to people who have held the stock for at least a certain amount of time. In general, this means that the person who gets the stock must have owned it for at least 46 days during the 91-day period that starts 45 days before the ex-dividend date.
For dividends on preferred stock that are attributable to more than 366 days, the required holding period is extended to 91 days during the 181-day period that starts 90 days before the ex-dividend date. In some cases, the taxpayer doesn’t have to count the time when he or she took steps to reduce the risk of loss on the stock.
Taxable income limitation
The dividends-received deduction is limited to a certain percentage of income. If your company owns less than 20% of the paying company, you can only deduct up to 50% of your company’s taxable income (modified to exclude certain items). But the limit doesn’t apply 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.
Let’s say your company gets $50,000 in dividends from a company that owns less than 20% of it and loses $10,000 from its regular operations. If there was no loss, the dividends-received deduction would be $25,000 (half of $50,000). But since the taxable income used to compute the dividends-received deduction is $40,000, the deduction is limited to $20,000 (50 percent of $40,000).
If the dividend payer is a foreign company, there are different rules that apply. Contact us to talk about how to use this deduction.