What Is a Deemed Dividend?

What Is a Deemed Dividend?
Image Credit: Violka08/iStock/GettyImages

A deemed dividend is a tax instrument used by publicly traded corporations as a means of shifting tax liability from shareholders during the sale of company stock. The IRS also permits the use of a deemed dividend as a means of spreading out investor tax liability to maximize deductions. These avoidance strategies encourage more investors to enter the market by allowing them to keep more earnings from successful investing.

Deemed Dividend Definition

A deemed dividend pays the taxes, also called capital gains taxes, on a shareholder's percentage of company profits,. In turn, the shareholder increases the cost basis of his existing company shares by the amount of taxes the company pays on his percentage of profits. This provides a means for the company to increase stock value even while paying out additional money in capital gains taxes. Cost basis is the total price per share of stock, including all fees and commissions related to the sale of the stock.

Shareholder Tax Liability

A shareholder reduces her tax liability when receiving a deemed dividend because the company she is investing in is paying the capital gains tax for her. In essence, this means the dividend the investor receives is 100 percent profit. The investor still retains tax obligations to declare the receipt of the dividend and must file IRS Form 2439 at the conclusion of the tax year. If the company makes an insufficient tax payment on the deemed dividend, the shareholder retains responsibility for making up the difference to the IRS.

Affect on Stock Prices

A deemed dividend might seem like the perfect scenario for an investor, but it has some drawbacks. Since the shareholder increases the cost basis of his company's shares, it reduces the potential return on investment through the sale of the shares because these profits disappear while paying fees and commissions. This also makes the company's shares an unattractive buy for new investors, because the cost basis weighs down the value of the share. No investor wants to purchase a stock for $20 a share when the actual value of the share is closer to $5 per share.

Foreign Investment Taxes

A U.S. citizen receiving profits from a passive foreign investment company (PFIC) may use a deemed dividend as a means of deferring taxation on investment profits. The deferment spreads out an investor's tax liability over multiple years making it easier to claim deductions and reduce capital gains taxes. A shareholder declares her decision to defer taxation of foreign investment profits using IRS form 8621. A shareholder must file a separate IRS Form 8621 for each PFIC she invests in.