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The taxation of dividends is one of the most complicated aspects of the U.S. tax system. For individuals, some types of dividends get taxed at different rates than others. But corporations are sometimes eligible for even bigger write-offs on dividends they receive, thanks to the dividends received deduction. The dividends received deduction, or DRD for short, allows corporations to deduct a percentage of their dividend income. That percentage can vary, however, depending on whether the corporation meets certain tests. Below, we'll take a closer look at the dividends received deduction and its requirements.

How the dividends received deduction works

The DRD guidelines are laid out in Section 243 of the Internal Revenue Code. The general rule is that if a company receives dividends from another corporation, then it is allowed to deduct 70% of those dividends under the DRD. That effectively cuts the tax rate on dividends from a top corporate rate of 35% down to 10.5%.

However, there are other rules that apply under certain specific situations. If the corporation receives the dividends from a small-business investment company as defined under small-business law, then it can deduct 100% of the dividends, effectively paying no tax at all. Similarly, for qualifying dividends paid by a corporation that's in the same affiliated group, the 100% deduction applies under the DRD.

Finally, a separate rule offers a different DRD amount. If the corporation receiving the dividend owns at least a 20% stake in the company paying the dividends, then the DRD amount rises to 80%. That cuts the tax rate all the way to 7% on dividend income received.

Does the DRD make sense?

The idea behind the dividends received deduction is to avoid multiple levels of taxation. In general, the U.S. tax system levies two levels of tax on corporate profits: a tax on profits, which is paid by the corporation, and a tax on the dividends that the corporation's individual shareholders receive. What the DRD does is alleviate the potential for three or more levels of tax -- one each for every corporate entity in a given overarching consolidated business structure. Theoretically, without the DRD, corporate tax on every transfer from a company to its corporate shareholders would require a portion of the payment to be siphoned off as tax. The DRD lessens that impact and, in certain circumstance, eliminates it completely.

However, there are limits on the DRD that are intended to prevent abuse by corporate taxpayers. Corporations generally must have net taxable income to offset the deduction, and the corporation's holding period must be 45 days or longer. Debt-financed stock purchases don't qualify for the DRD, preventing companies from using artificial financial constructs to reap the deduction.

Nevertheless, the dividends received deduction achieves its stated purpose for the most part. By offering relief from potentially unlimited taxation, the DRD provides a roughly even playing field throughout the tax system for dividend income.

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