Note: This explanation is not applicable to an “S” corporation.

This deduction is designed to reduce or eliminate the “extra” level of tax on dividends between corporations. As a result of the dividends received deduction, a corporation would often prefer dividend income to capital gains-exactly the reverse of the goal for individual tax planning.

In most cases, the deduction is 70% of the amount received, with the result that only 30% of the amount of dividends received is effectively subject to tax. For example, if your corporation receives $1,000 in dividends, it includes $1,000 in income but can claim a $700 dividends-received deduction, so that the net effect on taxable income is to increase it only by $300.

The percentage of dividends received which is deductible may be higher depending on the degree of ownership. If your corporation owns 20% or more (by vote and value) of the payor corporation, the deduction percentage is increased to 80%. And if your corporation is part of an affiliated group of corporations, dividends it receives from other group members can be offset by a full (100%) deduction. In general, 80% ownership and consistent treatment among group members in claiming a deduction or credit for foreign taxes is required to qualify for the 100% deduction.

In the case of certain extraordinary dividends, the basis of the stock on which the dividends are paid is reduced by the amount which effectively goes untaxed because of the dividends received deduction. If the reduction exceeds the basis of the stock, gain is recognized.

Special rules apply to dividends on public utility preferred stock.

Holding period requirement. The dividends-received deduction is only available for dividends on stock as to which the recipient has a minimum holding period. In general, the recipient of the dividend must own the stock for at least 46 days during the 90-day period beginning 45 days before the ex-dividend date. For dividends on preferred stock attributable to a period of more than 366 days, the required holding period is extended to 91 days during the 180-day period beginning 90 days before the ex-dividend date. Under certain circumstances, periods during which the taxpayer has hedged its risk of loss on the stock are not counted.

The taxable income limitation. The dividends received deduction is subject to a set of fairly complex limitations, designed to ensure that the dividends received deduction cannot be used to eliminate more than a certain percentage of the recipient’s taxable income. Where your corporation owns less than 20% of the payor corporation, the deduction is limited to 70% of your company’s taxable income (modified for these purposes to exclude net operating loss deductions carried from other years, capital loss carrybacks from future years, and the dividends received deduction itself). However, if allowing the full (70%) dividends received deduction without the taxable income limitation would result in (or increase) a net operating loss deduction for the year, the limitation doesn’t apply.

 Example (1). ABC, Inc., receives $50,000 in dividends from a less-than-20% owned corporation. It has a $10,000 loss from its regular business operations. The regular dividends received deduction would be $35,000 (70% of $50,000). However, since ABC’s taxable income for purposes of the dividends received deduction is $40,000, the deduction is limited to $28,000 (70% of $40,000).

 Example (2). The facts are the same except that ABC, Inc., has a $20,000 loss from its business operations. Here, taxable income for dividends received deduction purposes is $30,000 so that the “full” $35,000 dividends received deduction would result in a net operating loss for the year. Under the exception, the full dividends received deduction is allowed.

If your company owns 20% or more of the paying corporation, the limitation percentage is 80% instead of 70%. The limitation rules grow more complex where the dividends your company receives come from a combination of 20%-owned and non-20%-owned corporations.