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Corporations provide a return to their investors by paying dividend distributions. These payment amounts represent earnings that have accumulated in prior periods. Accumulated earnings reside in the equity section of a company's balance sheet. A reduction to equity by virtue of a dividend distribution does not generally constitute a taxable event for federal income tax purposes. Taking another perspective on the matter, note that a corporation figures its accumulated earnings every year on a net basis. This means that all deductible expenses have already been applied against gross income in determining net earnings. Therefore, when a corporation pays a dividend, it does not get another tax deduction because it has previously deducted all allowable expenses in calculating the underlying earnings amount.
Shareholders receiving dividends take them into account as a form of taxable income. As a general rule, the Internal Revenue Service taxes citizens on all income from whatever source derived. Some notable exceptions to the rule exist, however. Namely, individual shareholders receiving qualifying dividends treat the income similar to a capital gain. A lower rate of tax (usually 15 percent for most taxpayers) applies to capital gains. In order for dividends to qualify for the reduced tax rate, the underlying corporate stock generally must
be held for more than 60 days.
Corporations with dividend income do not get a reduced capital gains tax rate, but they usually can claim a dividends received deduction. The magnitude of a dividends received deduction depends on the relative ownership stake maintained in the distributing corporation. The tax code typically allows a deduction for the full amount of a dividend received from a company owned 80 percent or more. A corporate shareholder owning between 20 percent and 79 percent of a company may deduct 80 percent of a dividend received. An ownership interest of less than 20 percent gives rise to a 70 percent dividend received deduction.
Controlled Foreign Corporations
Note that corporate shareholders may not take a dividend received deduction for any dividend received from a controlled foreign corporation. The law deems control to exist with a greater than 50 percent ownership stake in the foreign corporation. However, dividends received from controlled foreign corporations may qualify for a foreign tax credit offset to corporate income tax liability. The amount of the credit is proportional to the amount of foreign taxes actually paid by the controlled foreign corporation on the underlying earnings. Note that only corporate (and not individual) shareholders get credits for taxes paid by their controlled foreign corporations.