Table of Contents
- What Is the Dividends Received Deduction (DRD)?
- Understanding the Mechanism of the Dividends Received Deduction (DRD)
- Important Note on Small Business Investment Companies
- Important Exceptions to the Dividends Received Deduction (DRD)
- Real-World Example of the Dividends Received Deduction (DRD)
- The Bottom Line
What Is the Dividends Received Deduction (DRD)?
Let me explain the Dividends Received Deduction, or DRD, directly to you. It's a tax provision that allows U.S. corporations to deduct dividends they receive from related entities, which reduces their taxable income and helps prevent what could be triple taxation. The benefits you get depend on how much ownership you have in the company paying the dividends, with deduction rates from 50% to 100%. You need to follow specific rules to qualify for this deduction.
Key Takeaways
- The DRD mitigates triple taxation on corporate dividends.
- It lets corporations deduct a portion of received dividends based on their ownership in the paying company.
- The Tax Cuts and Jobs Act changed DRD percentages for dividends from domestic corporations.
- Dividends from REITs and regulated investment companies don't qualify for DRD.
- Foreign corporation dividends can be 100% deductible if you meet certain criteria.
Understanding the Mechanism of the Dividends Received Deduction (DRD)
Here's how the DRD works: If your company receives a dividend from another company, you can deduct that amount from your income to lower your tax bill. But there are technical rules you must follow to claim it. The deduction amount depends on your ownership percentage in the paying company.
The Tax Cuts and Jobs Act, or TCJA, made big changes to corporate taxation, including lowering the DRD rates for domestic dividends. For tax years after December 31, 2017, if you own less than 20% of the distributing corporation, you can deduct 50% of the dividends, with some limits. If you own 20% or more, you can deduct 65%. These limits don't apply if your corporation has a net operating loss for that year.
This deduction aims to reduce triple taxation, where the same income gets taxed at the paying company, then at your receiving company, and again when you pay dividends to your shareholders.
Important Note on Small Business Investment Companies
You should know that small business investment companies can deduct 100% of dividends from taxable domestic corporations.
Important Exceptions to the Dividends Received Deduction (DRD)
Not all dividends qualify for the DRD. For instance, you can't deduct dividends from a real estate investment trust, or REIT. If the distributing company is tax-exempt under IRC sections 501 or 521 for the current or previous year, no deduction is allowed. You also can't deduct capital gain dividends from regulated investment companies.
For foreign corporations, the rules differ. You can often deduct 100% of the foreign-source portion from 10%-owned foreign corporations, but you must hold the stock for at least 365 days to qualify.
Real-World Example of the Dividends Received Deduction (DRD)
Consider this example: Suppose your company, ABC Inc., owns 60% of DEF Inc. and has $10,000 in taxable income, including a $9,000 dividend from DEF. You would get a DRD of $5,850, which is 65% of $9,000.
Keep in mind there are limits on the total deduction. Sometimes you need to check for a net operating loss by calculating the DRD without the 50% or 65% taxable income limit. For details, look at IRS Publication 542 or Form 1120, Schedule C instructions.
The Bottom Line
The DRD is essential for U.S. corporations to avoid triple taxation on dividends. By knowing the eligibility rules and deduction levels, you can reduce your taxable income from domestic or foreign dividends. The TCJA adjusted the limits, but REITs and certain other investments remain ineligible. Make sure you're aware of these rules to maximize your benefits.
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