Updated: February 20, 2023
KEY TAKEAWAYS
- A dividend exclusion is a provision that is allocated by the IRS.
- It allows corporations to subtract a portion of the dividends they receive. This is when they are calculating their taxable income.
- Dividend exclusions are only applicable to corporations and their investments. They do not apply to individual shareholders.
- The main aim of a dividend exclusion is to prevent corporate entities from incurring double taxation.
What Is Dividend Exclusion?
Dividends are distributions of a corporation’s profits to its shareholders. They can be distributions of money, stock, or other property. Dividend exclusion is a term regularly used for an Internal Revenue Service (IRS) provision. This provision allows corporations to take away a portion of dividends received when they are calculating their taxable income.
Dividend exclusions only apply to corporate entities and whatever investments that they have in other companies. This exclusion does not apply to individual shareholders. The main aim of a dividend exclusion is to avoid double taxation taking place.
Criteria for Dividend Exclusion
The criteria for each level of dividend exclusion are as follows:
- When a corporation owns less than a 20% stake of the other business, it is allowed to deduct 50% of the dividends received from it.
- When a corporation owns a 20% or more stake of the other business, it is allowed to deduct 65% of the dividends received from it.
Benefits of Dividend Exclusion
Dividend exclusion allows corporate entities to deduct dividends received from their investments. This ensures that the dividends of the receiving entity are only taxed once, meaning they don’t incur double taxation. Before the rule was put into effect, corporations could be taxed twice. Once on their profits, then again on their dividends.
A dividend exclusion only applies to companies that are classified as domestic corporations. This means that any company that is defined as a foreign entity will not be eligible for this provision. In addition to this, only dividends that are issued by other domestic companies are eligible for this exclusion.
Dividend exclusions greatly benefit any eligible companies. This is because it prevents them from incurring double taxation. This leaves additional capital for a company to use in any way, shape, or form that can improve its financial health. This in turn would improve the value of its shares for its various shareholders.
Companies can use this extra capital for investment purposes, to improve their current operations, or even to expand their growth. If a company was considered undergoing debt financing for any activities that are business related, then additional capital from dividend exclusions could be made useful. This helps to avoid a debt burden and any interest payments.
Difference Between Dividend Exclusion and Dividend Received Deduction (DRD)
The dividends received deduction (DRD) is along the same lines as a dividend exclusion. The DRD is essentially a federal tax write-off for any corporate entities that are eligible. The difference between dividend exclusion and DRD is eligibility. Dividend exclusion, unlike DRD, can only be claimed by domestic corporations, and not foreign businesses.
This IRS provision aims to help to alleviate the potential consequences that come with triple taxation on publicly traded companies. This triple taxation happens when the company pays the dividend, when the company receives the dividend, and again when the shareholder is paid a dividend.
A Short History of Dividend Exclusions and the Tax Cuts and Jobs Act (TCJA)
In 2018, the passage of the Tax Cuts and Jobs Act (TCJA) changed specific provisions of dividend exclusions. Before this was changed, the rules were as follows:
- When a corporation owns less than a 20% stake of the other business, it is allowed to deduct 70% of the dividends received from it.
- When a corporation owns a 20% – 79% stake of the other business, it is allowed to deduct 75% of the dividends received from it.
- When a corporation owns more than or equal to an 80% stake of the other business, it is allowed to deduct all of the dividends received from it.
The new tax remine came in Jan. 1, 2018. This lowered the standard that dividends received a deduction from. The deduction was reduced from 70% to 50%. It also lowered the 80% dividends received deduction to 65%. This applied to dividends from corporate entities that have at least 20% of their stock owned by the corporation that was the recipient.
This new tax law also replaced the graduated corporate tax rate scheme. This used to have a top rate of 35% with a flat tax rate of 21% on every C corporation. When this is factored in, the reduced exclusions and the lower tax rate would likely result in about the same actual tax that is due on any received dividends.
With this lower tax rate, more businesses may be encouraged to operate with a corporate classification. This is especially true for those businesses that do not plan to issue dividends to their shareholders. Before this, partnerships had an advantage when it came to rates over C corporations, but that advantage has since been mitigated due to the new tax scheme. Especially if the deduction for pass-through incomes is proven to be limited in scope or absent altogether.
Summary
Dividend exclusions are a way for corporate entities to ensure that they do not undergo any form of double taxation. This is by allowing them to subtract a portion of their dividends received when they are calculating their taxable income.
It’s important to remember that this exclusion will only apply to corporate entities and their investments that they have in separate companies. It does not apply to a company’s individual shareholders.
Sandra Habiger is a Chartered Professional Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.
Written bySandra Habiger, CPA
Sandra Habiger is a Chartered Professional Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.
FAQS on Dividend Exclusion
How Much of a Dividend Is Tax-Free?
The tax rate on qualified dividends is 0%, 15%, or 20%. Though this is dependent on the taxable income and filing status of the party in question. The tax rate on ordinary dividends would be the same as the party’s regular income tax bracket.
Is Dividend an Allowable Expense?
Any cash or stock dividends that are distributed to the company’s various shareholders are not recorded as a business expense, and are not included on the company’s income statement.
Why Are Dividends Not Tax-Deductible?
A company will pay corporation tax on any profits it generates. Since dividend distributions are not reported on the income statement, they cannot be deducted as a business expense and reduce the tax owed by the company.
