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A simple summary of DRD and the impact of this lesser-known TCJA change
In addition to the headline impacts of TCJA, a lesser known change affects dividends received deductions ("DRD").
As we discuss in detail in our advanced accounting course, the dividends received deduction ("DRD") exists to prevent companies that are shareholders in other companies from paying a triple tax on dividends they receive from their investment in those companies. In the absence of the DRD, when a company ("investor") is a shareholder in another company ("affiliate"), any dividends the affiliate issues to the investor would face a triple tax: First, on the affiliate level (affiliate pays tax on income), next on the investor's corporate level (investor pays tax on income at the corporate level), and lastly on the investor's shareholder level. Here's an example:
In other words, income generated by an affiliate of $50 million, which investor owns 30% ($15 million), gets triple-taxed all the way down to $6.25 by the time the investor shareholders can cash the check. The DRD aims to lessen the blow of this triple tax by allowing the investor to deduct the majority of the dividends received at the corporate level. Specifically, prior to TCJA, the DRD allowed the investor to deduct 80% of the dividend income. Recalculating the example above with the DRD example would yield:
Keeping $8.39 million on $15 million is definitely better than keeping $6.25. So that's the goal of DRD.
The TCJA lowered corporate tax rates from 35% to 21% but did not intend on lowering the effective tax rate on received dividends. To correct for this, the TCJA simply lowered the DRD from 80% to 65% when a C-corporation owns anywhere between 20%-80% of the affiliate, such that:
Noticed that there is not a material difference on the overall tax on dividends received (7.0% vs 7.35%).
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