What is a Dividends Received Deduction?

A dividends received deduction is a specific term in US federal regulations on income tax. It refers to a deduction granted to a corporation to cover dividends received from another corporation that it partly owns. As a result, it is a rare example of a deduction applied to money that has been received by the taxpayer, rather than spent.

The purpose of the dividends received deduction is to limit the effects the same money being taxed repeatedly. US policy does allow for double taxation, which is the circumstance by which a company's profits are taxed and then shareholders are taxed on the dividends they receive from the company's post-tax profits. Without the dividends received deduction, there would be an extra layer of taxation: tax would be taken from a corporation's profits, the dividend paid to a second corporation with an ownership stake in the first corporation, and the dividends paid by the second corporation to individual stockholders.

There are three levels of dividends received deduction. If a corporation owns less than 20% of the stock in another corporation, it can deduct 70% of any dividends received from that stock from its own taxable income. If the corporation owns more than 20% of the stock in the other corporation, the proportion of dividends that can be deducted rises to 80%. If the corporation owns more than 80% of the stock in the other corporation, it can deduct dividends in their entirety.

There are some limitations on the deductions. Where a company is allowed to deduct 70% or 80% of the dividends from its taxable income, the deduction cannot exceed 70% or 80% of its own taxable income respectively. That means that in a situation where a company receives more in dividends than in its own pre-tax profits, it will be able to list a zero figure for taxable income for the year, but the excess deduction amount will be ignored. A company that is allowed to deduct the entire dividend amount can list a negative taxable income, which means some of the "loss" will usually be carried forward and offset against the next year's income figures.

The dividends received deduction only applies to stocks that the corporation has held for at least 45 days. This period cannot cover any time during which the corporation had the right or option to sell the stocks at a fixed price. The principle of this rule is that the deduction benefits are only available to corporations that carry the risks inherent to stock ownership.