Definition
The Dividends Received Deduction (DRD) is a tax deduction allowed by U.S. federal tax law for certain corporations that receive dividends from related entities. Its purpose is to mitigate triple taxation, which occurs when dividends are taxed at the corporate level, the shareholder level, and again in the recipient corporation’s income. The deduction ranges from 50% to 100% depending on the ownership level in the dividend-paying company.
Key Takeaways
- The Dividends Received Deduction (DRD) is a US-based tax incentive, which allows corporations to deduct dividends received from other domestic corporations, to a certain extent, from their taxable income. Its purpose is to alleviate the effect of triple taxation.
- The deduction percentage for the DRD is typically determined by the percentage of ownership the corporation has in the dividend-paying company. This percentage is typically grouped into three tiers – less than 20% ownership, between 20% and 80% ownership, and more than 80% ownership.
- The Dividends Received Deduction does not apply to dividends received from foreign corporations or for corporations owning stock in another corporation for 45 days or less during the applicable period.
Importance
The Dividends Received Deduction (DRD) is crucial in the finance world as it helps mitigate the potential issues arising from triple taxation.
Triple taxation refers to the situation in which the same income is taxed at the corporate level, dividend level, and personal income level.
The DRD allows corporations to deduct a portion, or in some cases the total, of the dividends received from investments in other corporations from their taxable income.
This ultimately reduces the tax burden a corporation has to bear, thus promoting domestic economic growth and encouraging corporations to invest in other corporations.
Therefore, the DRD plays a significant role in fostering internal investment and mitigating economic consequences associated with excessive taxation.
Explanation
The Dividends Received Deduction, often abbreviated as DRD, is a tax deduction applicable in the U.S. corporate income tax system designed to alleviate the potential consequences of triple taxation.
Triple taxation occurs when the same income gets taxed thrice at the corporate level, i.e., when earned, when distributed as dividends, and when dividends are received by the corporate shareholder. DRD serves to mitigate this burden by providing corporations with a significant tax deduction on the dividends received from other domestic corporations in situations where they own a stake.
The purpose and utilization of the Dividends Received Deduction are tied directly to encouraging corporate investments and a more seamless integration of corporate-related sectors. Companies are inclined to invest in other companies with the assurance that at least a portion of their investment will be recouped through tax deductions, promoting financial growth and cooperation within the business sphere.
The percentage of a dividend that can be deducted depends on the percentage of ownership the recipient has in the company paying the dividend. Overall, the DRD plays a crucial role in promoting investments and making the corporate tax structure fairer and balanced.
Examples of Dividends Received Deduction
Large Corporate Shareholder Example: Exxon Mobil Corporation is a multinational oil and gas corporation based in the U.S. Suppose it owns a significant stake in several other energy companies, such as Chevron and BP. When these companies distribute dividends to Exxon, those dividends are taxable. However, Exxon can take advantage of the Dividends Received Deduction, which allows it to deduct a portion of the dividend income it receives, thereby reducing its tax liability.
Small Business Example: Consider a small business that owns shares in a related business within the same industry. Let’s say a small book retailer owns shares in a larger wholesale book distributor. When the distributor pays dividends to the retailer, the retailer is eligible for the Dividends Received Deduction, which allows it to deduct a part of those dividends from its taxable income.
Retirement Fund Example: A retirement fund invests partly in stocks that pay dividends. When these dividends are received, they count as income for the fund. However, the Dividends Received Deduction allows the fund to deduct a portion of those dividends from its taxable income, preserving more of the fund’s assets for future payouts.
FAQs on Dividends Received Deduction
What is Dividends Received Deduction?
The Dividends Received Deduction (DRD) is a federal tax provision that allows U.S. corporations to deduct dividends received from other U.S. corporations from their taxable income. DRD aims to reduce the potential for triple taxation which can occur when dividends received by a corporation are taxed both at the level of the payer and the recipient, with tax also potentially paid at the individual shareholder level.
Who can claim the Dividends Received Deduction?
Only U.S. corporations can claim the Dividends Received Deduction. This includes Subchapter C corporations. Subchapter S corporations, partnerships, and individuals cannot claim the DRD.
What is the calculation basis for Dividends Received Deduction?
The calculation for Dividends Received Deduction varies depending on the percentage of ownership the receiving corporation has in the corporation paying the dividends. If the receiving corporation owns less than 20% of the distributing corporation, the deduction is calculated at 50%. If the receiving corporation owns between 20% and 80%, the deduction is made at 65%. If the receiving corporation owns more than 80%, the deduction is calculated at 100%
Is there any limitation to the application of Dividends Received Deduction?
Yes, the Dividends Received Deduction is subject to a limitation. The deduction cannot exceed the proportionate share of the taxable income of the recipient corporation, but there are exceptions for deficit years.
Related Entrepreneurship Terms
- Distribution policies: These are the guidelines a corporation follows to decide on the amount, timeline, and method of payment for dividends.
- Retained Earnings: This refers to the company’s net income that is not distributed as dividends but is retained by the company for reinvestment or to pay off debts.
- Qualified Dividend: A type of dividend to which capital gains tax rates are applied, which are typically lower than regular income tax rates.
- Taxation of Dividends: This term refers to the process and procedures that determine how much tax a company or individual pays on their dividend earnings.
- Dividend Yield: A financial ratio that indicates how much a company pays out in dividends each year relative to its share price.
Sources for More Information
- Internal Revenue Service (IRS) – The IRS is the U.S. government agency responsible for tax collection and tax law enforcement.
- Investopedia – This site provides a wealth of information on all kinds of financial topics including dividends.
- Accounting Tools – A professional resource for accountants and finance professionals offering detailed accounting information.
- Corporate Finance Institute – This website provides online training and education for the finance industry. Their resources could be very helpful in understanding the Dividends Received Deduction.
