What Is Dividend Exclusion?

Dividend exclusion refers to an Internal Revenue Service (IRS) provision that allows corporations to subtract a portion of dividends received when they calculate their taxable income. Dividend exclusions only apply to corporate entities and the investments that they have in other companies, it does not apply to individual shareholders. The purpose of a dividend exclusion is to avoid double taxation.

Key Takeaways

  • A dividend exclusion is a provision by the Internal Revenue Service (IRS) that allows corporations to deduct a portion of their dividends received when they calculate their taxable income.
  • A dividend exclusion is only applicable to corporate entities and their investments and does not apply to individual shareholders.
  • The reason for a dividend exclusion is to prevent corporations from having to incur double taxation.
  • The current law enacted by the Tax Cuts and Jobs Act states that if a corporation owns less than one-fifth of another company’s shares it can deduct 50% of dividends. If a corporation owns 20% or more of the company, it can deduct 65% of dividends.
  • Similar to dividend exclusion is the dividends received deduction, which is a tax write-off for corporations that receive dividends from related entities. This is to avoid triple taxation.

Understanding Dividend Exclusion

Dividend exclusion essentially allows corporations to deduct dividends received from their investments, ensuring that the dividends of the receiving entity are only taxed once. Before the rule, corporations could be taxed on their profits and then again on the dividends. Notably, dividend exclusion applies only to companies classified as domestic businesses and not foreign entities. In addition, only dividends issued by other domestic companies are eligible for the exclusion.

Along the same lines as the dividend exclusion is the dividends received deduction, also known as the DRD. The dividends received deduction is a federal tax write-off for eligible corporations in the U.S. that receive dividends from related entities. This IRS provision seeks to alleviate the potential consequences of triple taxation on publicly traded companies, i.e., when the same income is taxed for the company paying the dividend, the company receiving the dividend, and when the shareholder is paid a dividend.

Dividend Exclusion and the Tax Cuts and Jobs Act

Passage of the Tax Cuts and Jobs Act (TCJA) in late 2017 changed certain provisions of dividend exclusions. Previously, corporations that owned less than one-fifth of another company’s shares were able to deduct 70% of dividends. If a corporation owned up to 80% of the company, it could deduct 75% of dividends. Corporations that owned more than 80% of the other company were eligible to deduct all dividends.

Beginning Jan. 1, 2018, the new tax regime lowered the standard that dividends received a deduction from 70% to 50%. It also lowered the 80% dividends received deduction to 65%, which applies to dividends from corporations that have at least 20% of their stock owned by the recipient corporation.

The new tax law also replaces the graduated corporate tax rate scheme, which had a top rate of 35%, with a flat 21% tax rate on all C corporations. Factoring that in, the reduced exclusions and the lower tax rate will likely result in roughly the same actual tax due on dividends received.

The lower tax rate may encourage more businesses to operate with a corporate classification, particularly those that do not plan to issue dividends to their current shareholders. Previously, partnerships had a rate advantage over C corporations, but that advantage has been mitigated by the new tax scheme, particularly if the deduction for pass-through income proves limited in scope or altogether absent. 

Benefits of Dividend Exclusion

The dividend exclusion greatly benefits companies as it prevents them from incurring double taxation; paying taxes on the dividends and then paying taxes on their profits, which would include the dividend value.

This exclusion, therefore, leaves additional money on the table for a company to use in ways that can improve its financial health, which in return would improve the value of its shares for its shareholders. Companies can use the extra cash for investment purposes, to expand growth, or to improve current operations.

If a company was considering debt financing for any business-related activities, the additional cash obtained from dividend exclusions may make that unnecessary, avoiding a debt burden and interest payments.