Dividends-Received Deduction

A corporation can deduct a percentage of certain dividends received during its tax year. This section discusses the general rules that apply. For more information, see the instructions for Forms 1120 and 1120-A.

Dividends from domestic corporations.   A corporation can deduct, within certain limits, 70% of the dividends received if the corporation receiving the dividend owns less than 20% of the corporation distributing the dividend. If the corporation owns 20% or more of the distributing corporation's stock, it can, subject to certain limits, deduct 80% of the dividends received.

Ownership.   Determine ownership, for these rules, by the amount of voting power and value of the paying corporation's stock (other than certain preferred stock) the receiving corporation owns.

Small business investment companies.   Small business investment companies can deduct 100% of the dividends received from taxable domestic corporations.

Dividends from regulated investment companies.   Regulated investment company dividends received are subject to certain limits. Capital gain dividends received from a regulated investment company do not qualify for the deduction. For more information, see section 854 of the Internal Revenue Code.

No deduction allowed for certain dividends.   Corporations cannot take a deduction for dividends received from the following entities.

1. A real estate investment trust (REIT).
2. A corporation exempt from tax under section 501 or 521 of the Internal Revenue Code either for the tax year of the distribution or the preceding tax year.
3. A corporation whose stock was held less than 46 days during the 90-day period beginning 45 days before the stock became ex-dividend with respect to the dividend. Ex-dividend means the holder has no rights to the dividend.
4. A corporation whose preferred stock was held less than 91 days during the 180-day period beginning 90 days before the stock became ex-dividend with respect to the dividend if the dividends received are for a period or periods totaling more than 366 days.
5. Any corporation, if your corporation is under an obligation (pursuant to a short sale or otherwise) to make related payments with respect to positions in substantially similar or related property.

Dividends on deposits.   Dividends on deposits or withdrawable accounts in domestic building and loan associations, mutual savings banks, cooperative banks, and similar organizations are interest, not dividends. They do not qualify for this deduction.

Limit on deduction for dividends.   The total deduction for dividends received or accrued is generally limited (in the following order) to:

1. 80% of the difference between taxable income and the 100% deduction allowed for dividends received from affiliated corporations, or by a small business investment company, for dividends received or accrued from 20%-owned corporations, then
2. 70% of the difference between taxable income and the 100% deduction allowed for dividends received from affiliated corporations, or by a small business investment company, for dividends received or accrued from less-than-20%-owned corporations (reducing taxable income by the total dividends received from 20%-owned corporations).

Figuring the limit.   In figuring the limit, determine taxable income without the following items.

1. The net operating loss deduction.
2. The deduction for dividends received.
3. Any adjustment due to the nontaxable part of an extraordinary dividend (see Extraordinary Dividends, later).
4. Any capital loss carryback to the tax year.

Effect of net operating loss.   If a corporation has a net operating loss (NOL) for a tax year, the limit of 80% (or 70%) of taxable income does not apply. To determine whether a corporation has an NOL, figure the dividends-received deduction without the 80% (or 70%) of taxable income limit.

Example 1.   A corporation loses $25,000 from operations. It receives $100,000 in dividends from a 20%-owned corporation. Its taxable income is $75,000 ($100,000 - $25,000) before the deduction for dividends received. If it claims the full dividends-received deduction of $80,000 ($100,000 × 80%) and combines it with an operations loss of $25,000, it will have an NOL of ($5,000). Therefore, the 80% of taxable income limit does not apply. The corporation can deduct the full $80,000.

Example 2.   Assume the same facts as in Example 1, except that the corporation only loses $15,000 from operations. Its taxable income is $85,000 before the deduction for dividends received. After claiming the dividends-received deduction of $80,000 ($100,000 × 80%), its taxable income is $5,000. Because the corporation will not have an NOL after applying a full dividends-received deduction, its allowable dividends-received deduction is limited to 80% of its taxable income, or $68,000 ($85,000 × 80%).

Extraordinary Dividends

If a corporation receives an extraordinary dividend on stock held 2 years or less before the dividend announcement date, it generally must reduce its basis in the stock by the nontaxed part of the dividend. The nontaxed part is any dividends-received deduction allowable for the dividends.

Extraordinary dividend.   An extraordinary dividend is any dividend on stock that equals or exceeds a certain percentage of the corporation's adjusted basis in the stock. The percentages are:

1. 5% for stock preferred as to dividends, or
2. 10% for other stock.

Treat all dividends received that have ex-dividend dates within an 85-consecutive-day period as one dividend. Treat all dividends received that have ex-dividend dates within a 365-consecutive-day period as extraordinary dividends if the total of the dividends exceeds 20% of the corporation's adjusted basis in the stock.

Disqualified preferred stock.   Any dividend on disqualified preferred stock is treated as an extraordinary dividend regardless of the period of time the corporation held the stock.

Disqualified preferred stock is any stock preferred as to dividends if any of the following apply.

1. The stock when issued has a dividend rate that declines (or can reasonably be expected to decline) in the future.
2. The issue price of the stock exceeds its liquidation rights or stated redemption price.
3. The stock is otherwise structured to avoid the rules for extraordinary dividends and to enable corporate shareholders to reduce tax through a combination of dividends-received deductions and loss on the disposition of the stock.

These rules apply to stock issued after July 10, 1989, unless it was issued under a written binding contract in effect on that date, and thereafter, before the issuance of the stock.

More information.   For more information on extraordinary dividends, see section 1059 of the Internal Revenue Code.

Going Into Business

When you go into business, certain costs you incur to get your business started are treated as capital expenses. See Capital Expenses in chapter 1 of Publication 535 for a discussion of how to treat these costs if you do not go into business.

You can choose to amortize certain costs over a period of 60 months or more. To qualify, the cost must be one of the following.

1. A business start-up cost.
2. An organizational cost.

Business start-up costs.   Start-up costs are costs incurred for creating an active trade or business or for investigating the creation or acquisition of an active trade or business. Start-up costs include any amounts paid or incurred in connection with an activity engaged in for profit or for the production of income in anticipation of the activity becoming an active trade or business.

Qualifying costs.   A start-up cost is amortizable if it meets both of the following tests.

1. It is a cost you could deduct if you paid or incurred it to operate an existing active trade or business (in the same field).
2. It is a cost you pay or incur before the date your active trade or business begins.

Start-up costs include costs for the following.

• An analysis or survey of potential markets, products, labor supply, transportation facilities, etc.
• Advertisements for the opening of the business.
• Salaries and wages for employees who are being trained, and their instructors.
• Travel and other necessary costs for securing prospective distributors, suppliers, or customers.
• Salaries and fees for executives and consultants, or for similar professional services.

Nonqualifying costs.   Start-up costs do not include deductible interest, taxes, or research and experimental costs.

Purchasing an active trade or business.   Amortizable start-up costs for purchasing an active trade or business include only investigative costs incurred in the course of a general search for, or preliminary investigation of, the business. Investigative costs are costs that help you decide whether to purchase any business and which business to purchase. Alternatively, costs you incur in an attempt to purchase a specific business are capital expenses and you cannot amortize them.

Disposition of business.   If you completely dispose of your business before the end of the amortization period, you can deduct any remaining deferred start-up costs to the extent allowable under section 165 of the Internal Revenue Code.

Organizational costs.   The costs of organizing a corporation are the direct costs of creating the corporation.

Qualifying costs.   You can amortize an organizational cost only if it meets all of the following tests.

1. It is for the creation of the corporation.
2. It is chargeable to a capital account.
3. It could be amortized over the life of the corporation, if the corporation had a fixed life.
4. It is incurred before the end of the first tax year in which the corporation is in business. A corporation using the cash method of accounting can amortize organizational costs incurred within the first tax year, even if it does not pay them in that year.

The following are examples of organizational costs.

• The cost of temporary directors.
• The cost of organizational meetings.
• State incorporation fees.
• The cost of accounting services for setting up the corporation.
• The cost of legal services (such as drafting the charter, bylaws, terms of the original stock certificates, and minutes of organizational meetings).

Nonqualifying costs.   The following costs are not organizational costs. They are capital expenses that you cannot amortize.

• Costs for issuing and selling stock or securities, such as commissions, professional fees, and printing costs.
• Costs associated with the transfer of assets to the corporation.

How to amortize.   Deduct start-up and organizational costs in equal amounts over a period of 60 months or more. You can choose an amortizable period for start-up costs that is different from the period you choose for organizational costs, as long as both are not less than 60 months. The amortization period starts with the month you begin business operations. Once you choose an amortization period, you cannot change it.

To figure your deduction, divide your total start-up or organizational costs by the months in the amortization period. The result is the amount you can deduct for each month.

How to make the choice.   To choose to amortize start-up or organizational costs, you must attach Form 4562 and an accompanying statement to your return for the first tax year you are in business. If you have both start-up and organizational costs, attach a separate statement to your return for each type of cost.

Generally, you must file your return by the due date (including any extensions). However, if you timely filed your return for the year without making the choice, you can still make the choice by filing an amended return within 6 months of the due date of the original return (not including extensions). For more information, see the instructions for Part VI of Form 4562.

Once you make the choice to amortize start-up or organizational costs, you cannot change it.

Start-up costs.   If you choose to amortize your start-up costs, complete Part VI of Form 4562 and prepare a separate statement that contains the following information.

• A description of the business to which the start-up costs relate.
• A description of each start-up cost incurred.
• The month your active business began (or was acquired).
• The number of months in your amortization period (not less than 60).

You can choose to amortize your start-up costs by filing the statement with a return for any tax year prior to the year your active business begins. If you file the statement early, the choice becomes effective in the month your active business begins.

You can file a revised statement to include any start-up costs not included in your original statement. However, you cannot include on the revised statement any cost you previously treated on your return as a cost other than a start-up cost. You can file the revised statement with a return filed after the return on which you chose to amortize your start-up costs.

Organizational costs.   If you choose to amortize your organizational costs, complete Part VI of Form 4562 and prepare a separate statement that contains the following information.

• A description of each cost.
• The amount of each cost.
• The date each cost was incurred.
• The month your active business began (or was acquired).
• The number of months in your amortization period (not less than 60).

Related Persons

A corporation that uses an accrual method of accounting cannot deduct business expenses and interest owed to a related person who uses the cash method of accounting until the corporation makes the payment and the corresponding amount is includible in the related person's gross income. Determine the relationship, for this rule, as of the end of the tax year for which the expense or interest would otherwise be deductible. If a deduction is denied under this rule, the rule will continue to apply even if the corporation's relationship with the person ends before the expense or interest is includible in the gross income of that person. These rules also deny the deduction of losses on the sale or exchange of property between related persons.

Related persons.   For purposes of this rule, the following persons are related to a corporation.

1. Another corporation that is a member of the same controlled group as defined in section 267(f) of the Internal Revenue Code.
2. An individual who owns, directly or indirectly, more than 50% of the value of the outstanding stock of the corporation.
3. A trust fiduciary when the trust or the grantor of the trust owns, directly or indirectly, more than 50% in value of the outstanding stock of the corporation.
4. An S corporation if the same persons own more than 50% in value of the outstanding stock of each corporation.
5. A partnership if the same persons own more than 50% in value of the outstanding stock of the corporation and more than 50% of the capital or profits interest in the partnership.
6. Any employee-owner if the corporation is a personal service corporation (defined later), regardless of the amount of stock owned by the employee-owner.

Ownership of stock.   To determine whether an individual directly or indirectly owns any of the outstanding stock of a corporation, the following rules apply.

1. Stock owned, directly or indirectly, by or for a corporation, partnership, estate, or trust is treated as being owned proportionately by or for its shareholders, partners, or beneficiaries.
2. An individual is treated as owning the stock owned, directly or indirectly, by or for his or her family. Family includes only brothers and sisters (including half brothers and half sisters), a spouse, ancestors, and lineal descendants.
3. Any individual owning (other than by applying rule (2)) any stock in a corporation is treated as owning the stock owned directly or indirectly by that individual's partner.
4. To apply rule (1), (2), or (3), stock constructively owned by a person under rule (1) is treated as actually owned by that person. But stock constructively owned by an individual under rule (2) or (3) is not treated as actually owned by the individual for applying either rule (2) or (3) to make another person the constructive owner of that stock.

Personal service corporation.   For this purpose, a corporation is a personal service corporation if it meets all of the following requirements.

1. It is not an S corporation.
2. Its principal activity is performing personal services. Personal services are those performed in the fields of accounting, actuarial science, architecture, consulting, engineering, health (including veterinary services), law, and performing arts.
3. Its employee-owners substantially perform the services in (2).
4. Its employee-owners own more than 10% of the fair market value of its outstanding stock.

Reallocation of income and deductions.   Where it is necessary to clearly show income or prevent tax evasion, the IRS can reallocate gross income, deductions, credits, or allowances between two or more organizations, trades, or businesses owned or controlled directly, or indirectly, by the same interests.

Complete liquidations.   The disallowance of losses from the sale or exchange of property between related persons does not apply to liquidating distributions.

More information.   For more information about the related person rules, see Publication 544.

U.S. Real Property Interest

If a domestic corporation acquires a U.S. real property interest from a foreign person or firm, the corporation may have to withhold tax on the amount it pays for the property. The amount paid includes cash, the fair market value of other property, and any assumed liability. If a domestic corporation distributes a U.S. real property interest to a foreign person or firm, it may have to withhold tax on the fair market value of the property. A corporation that fails to withhold may be liable for the tax, and any penalties and interest that apply. For more information, see U.S. Real Property Interest in Publication 515, Withholding of Tax on Nonresident Aliens and Foreign Entities.

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