One reason the tax laws are so difficult for many people to understand is that different types of income get taxed at different rates. Dividend income in particular gets treated in several different ways, with special tax rates applying for certain dividends, and certain taxpayers getting preferential treatment with dividend income. The DRD deduction as stated in Section 243 of the Internal Revenue Code allows some corporations to deduct between 70% and 80% of dividend income that the corporation earns, while others get what amounts to a complete exclusion of dividends from taxable income.
This corporate tax rule might sound like an unfair break compared to how individuals are treated, but in reality, it can prevent what would otherwise be triple taxation of income. Let's take a closer look at the DRD deduction.
Corporations like to save on taxes too. Image source: Getty Images.
The basics of the DRD deduction
The DRD deduction typically allows most corporations to deduct 70% of dividends it receives from other corporations. For corporations that pay the maximum corporate tax rate of 35%, this amounts to a 24.5-percentage-point reduction in their tax rate on qualifying dividends.
The reason for the DRD deduction is to avoid potentially infinite levels of taxation. Without the deduction, the corporation paying the dividend would have to pay tax on its income, because dividends paid don't give rise to a deduction. The receiving corporation would also have to pay tax on the dividends received, and then that second corporation's individual shareholders would face a third level of taxation when it subsequently paid out dividends.
For corporations that are more closely related, larger DRD deductions are available. If the company paying the dividend has at least 20% of its shares owned by the company receiving the dividend, then the DRD deduction rises to 80% of the dividends paid. If the two corporations are in the same affiliated group for accounting purposes, then a 100% DRD deduction is allowed. Again, although this looks like it makes the dividend tax-free, really all it does is to avoid penalizing the corporations from making money transfers within the affiliated group. Corporations that get dividends from small-business investment companies also qualify for the 100% DRD deduction.
Limitations on the DRD deduction
As lucrative as the DRD deduction can be, there are limits on its availability. Certain types of corporations, including tax-exempt organizations under Section 501 of the Internal Revenue Code and farmers' cooperative associations, aren't allowed to have dividends treated as deductible. Similarly, certain Federal Home Loan Bank dividends don't get the deduction.
In addition, there are holding-period rules that govern the DRD deduction. Typically, a corporation has to own the stock in question for at least 46 out of the 91 days surrounding the ex-dividend date for the particular dividend payment. For preferred stock, the tax laws impose a similar rule but with different lengths of time involved, requiring ownership for at least 91 days out of the 181-day period surrounding the ex-dividend date.
Finally, corporations can't game the system by hedging their exposure to a stock while they own shares. If options or other derivatives limit risk, then the tax law effectively doesn't count the days during which the corporation's risk is limited. Even hedges involving slightly different types of investment property disqualify the DRD deduction if they are substantially similar or related to the investment in question.
Despite these limits, corporations still get a valuable benefit from the DRD deduction. Without it, corporations would face unfair multiple levels of taxation that would make using the corporate structure a huge burden on tax-paying businesses.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at [email protected]. Thanks -- and Fool on!
