The United States' federal income tax system characterizes dividends as something distinct from other types of payments or receipts. Special rules within the Internal Revenue Code govern the tax implications for corporations distributing dividend payments, as well as shareholders receiving dividend income. For dividend recipients, taxation often depends on the nature of the shareholder relationship.
Dividends Paid Deduction For Corporations
Corporations provide a return to their investors by paying dividend distributions. These payment amounts represent earnings that have accumulated in prior periods. Accumulated earnings reside in the equity section of a company's balance sheet. A reduction to equity by virtue of a dividend distribution does not generally constitute a taxable event for federal income tax purposes.
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Taking another perspective on the matter, note that a corporation figures its accumulated earnings every year on a net basis. This means that all deductible expenses have already been applied against gross income in determining net earnings. Therefore, when a corporation pays a dividend, it does not get another tax deduction because it has previously deducted all allowable expenses in calculating the underlying earnings amount.
Dividend Income Deduction for Recipients
Shareholders receiving dividends take them into account as a form of taxable income. As a general rule, the Internal Revenue Service taxes citizens on all income from whatever source derived. Some notable exceptions to the rule exist, however. Namely, individual shareholders receiving qualifying dividends treat the income similar to a capital gain.
A lower rate of tax (0 to 20 percent depending on income and filing status) applies to capital gains. In order for dividends to qualify for the reduced tax rate, the underlying corporate stock generally must be held for more than 60 days.
Consider also: Who Must File Income Taxes?
Rules for Corporate Recipients
Corporations with dividend income do not get a reduced capital gains tax rate, but they usually can claim a dividends received deduction. The magnitude of a dividends received deduction depends on the relative ownership stake maintained in the distributing corporation.
Following the Tax Cuts and Jobs Act, the receiving corporation can deduct 80 percent of the dividends received, as long as the corporation owns between 20 percent and 80 percent of the corporation distributing the dividend, reports consulting giant PWC. The rules are complex and restrictions apply. In particular, there are different rules if the corporation is reporting a net operating loss for the tax year.
Controlled Foreign Corporations
Note that corporate shareholders may not take a dividend received deduction for any dividend received from a controlled foreign corporation. The law deems control to exist with a greater than 50 percent ownership stake in the foreign corporation. However, dividends received from controlled foreign corporations may qualify for a foreign tax credit offset to corporate income tax liability.
The amount of the credit is proportional to the amount of foreign taxes actually paid by the controlled foreign corporation on the underlying earnings. Note that only corporate (and not individual) shareholders get credits for taxes paid by their controlled foreign corporations.