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. 

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 US 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 in late 2017 changed certain provisions of dividend exclusion. Previously, corporations that owned less than one-fifth of another company’s shares were able to deduct 70 percent of dividends. If a corporation owned up to 80 percent of the company, it could deduct 75 percent of dividends. Corporations that owned more than 80 percent of the other company were eligible to deduct all dividends.

Beginning January 1, 2018, the new tax regime lowers the standard dividends received a deduction from 70 to 50 percent. It also lowers the 80 percent dividends received deduction to 65 percent; it applies to dividends from corporations that have at least 20 percent 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 percent, with a flat 21 percent 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.