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About Dividend Received Deductions
Dividends Received Deduction Definition
Under I.R.C. § 243, a corporation can qualify for the Dividends Received Deduction (DRD) on a dividend when it meets certain criteria and thus becomes eligible for a preferable tax treatment.
A dividend is a distribution (cash, stock, or other property) from a corporation or a mutual fund paid to the shareholder of that corporation or mutual fund out of corporate profits. When dividends are paid to an individual taxpayer, they are normally taxed at an individual’s normal or qualified dividend income rates. It should be noted that dividends received by an individual taxpayer are subject to double taxation. First, the corporate entity is taxed at 35% to earn the money required to issue the dividend. The remaining 65% is disbursed to the individual who pays 23.8% in federal taxes. This makes the ‘true’ tax rate for dividends 50.47%.
However, if the dividend is paid by Corporation X to Corporation Y who in turn pays the dividend to a shareholder in Corporation Y, we can see how the dividend has been taxed THREE times (twice at 35% and once at 23.8%) forcing the taxpayer to concede almost 68% of his earnings to the federal government. The case becomes worse when Corp Z pays dividends to Corp X who pays dividends to Corp Y who pays them to an individual. . .
So Congress decided that double taxation is OK but triple (or more) taxation is “right out.” For this reason, dividends received by a Corporation (or other non-pass-through) are 70% exempt from taxation unless they become disqualified.
However when determining a taxpayer’s dividend income, it is important to understand the interaction between dividends and other taxable events, namely constructive sales and straddles.
The dividends received deduction established by 26 USC § 243 has an entirely separate history from that of taxation of certain income of tax exempt organizations. The policy behind it was explained in Revenue Ruling 104, 1953-1 C.B. 68:
“The credit for dividends received ... is based upon a theory that a corporate tax has already been paid upon the earnings out of which the dividends are distributed.”
A corporate tax, in other words, has already been paid on the earnings which generate the dividends before they are distributed. Congress felt that it would result in excessive taxation to tax such dividends fully again as earnings of the receiving corporation, and once more when those earnings are distributed as dividends to the shareholders. At that stage, the earnings would have been taxed three (or more) times before their enjoyment as after tax income by the shareholders. See Sen.Rep. 94-1318, 94th Cong., 2d Sess. 6, reprinted in 1976 U.S.Code Cong. & Admin. News 6056.
How to qualify for DRD treatment
To qualify for DRD treatment, a number of requirements must be met, among them the following:
- The deduction cannot be larger than the recipient’s taxable income (with certain adjustments).
- You meet the holding period (46 days normally). However, the holding period shall be adjusted if the taxpayer has an option to sell, a requirement to sell or has an open short sale of the same or substantially identical securities. RR 1994-28 states that the principle behind §246(c)(4) is to suspend the holding period during any period which the taxpayer is protected from risk of loss.
- If corporate debt is used to purchase the dividend producing securities, the dividends received are not eligible for DRD treatment (Code Section 246A). If corporate debt was used to finance only part of the purchase, then the percentage of the dividend is deductible shall be reduced proportionately.
I.R.C. § 243 defines when corporations are qualified for preferential tax treatment on a dividend (0%). “There is a holding period requirement to be eligible for the lower tax rate, defined in section 246. A taxpayer must have held the stock for more than 45 days during the 91-day period that begins 45 days before the ex-dividend date.”
Days where a taxpayer has diminished his risk of loss are not counted toward the holding-period requirement. To determine whether or not the holding period has been met, factors that reset the holding period and those that suspend the holding period must be considered. Straddles and Constructive Sales both affect how holding period days are counted. Increases in the holding period due to wash sales are ignored for this purpose.
We have several resources you can consult for more information on all of these topics. Please see our About Straddles and our About Constructive Sales sections for information on these taxable events.
Our Qualified Dividend Income white paper discusses the interaction of qualified dividends, straddles and constructive sales in more detail.
For a discussion on determining when risk of loss is diminished, please see our white paper, Using Market Risk Concepts to Refactor Tax Shelters.
Tax Analysis of Securities Transactions (TAST)
The fund buys 1,000 shares of company ABC stock. The original purchase date (tax lot date) is 6/1/2011. ABC issued a $0.05 dividend with an ex-date of 6/20/2011. The stock is later sold on 8/25/2011.
Result: The qualification period is: 6/20/2011 – 45 days = 5/6/2011 through 5/6/2011 + 90 days = 8/5/2011. The stock must be held for more than 45 of the days between 5/6/2011 and 8/5/2011. We see that the stock is held from 6/1/2011 through 8/25/2011 and constitutes 85 days, 80 of which fall inside the 91-day window; since 80 is greater than 45, the dividend is qualified for the DRD.
Click here to access Pub 550, the IRS publication that provides information and guidance on complying with sections of the Internal Revenue Code (IRC) that pertain to investment income and expenses.
Tax Analysis of Dividends
Relevant video clip
Dividends Received Deductions
Relevant white papers
Qualified Dividend Income
Tax Implications of Straddles
Using Market Risk Concepts to Refactor Tax Shelters