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The President's Proposed Dividend Exclusion
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April, 2003 Hot Topics
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Current Law
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Income earned by a corporation is taxed at the corporate level, generally at the rate of
35 percent. If the corporation distributes earnings to shareholders in the form of
dividends, the income generally is taxed a second time at the shareholder level (at rates
as high as 38.6 percent).
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Overview
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Under newly proposed dividend exclusion legislation, Public and private
corporations would be permitted to distribute nontaxable dividends to shareholders to the
extent those dividends are paid out of income previously taxed at the corporate level. The
proposal generally would be effective for distributions made on or after January 1, 2003,
with respect to corporate earnings after 2000.
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Excludable Dividend Amount
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To calculate the amount that can be distributed to
shareholders without further tax, a corporation will compute an excludable dividend amount
(EDA) for each year. The EDA reflects income of the corporation that has been fully taxed.
Thus, for example, a corporation with $100 of income that pays $35 of U.S. income taxes
will have an EDA of $65 that can be distributed as excludable dividends.
If an amount would be a dividend under current law, it will be treated as an excludable
dividend to the extent of EDA. Excludable dividends will not be taxed to shareholders. If
a corporation's distributions during a calendar year exceed its EDA, only a proportionate
amount of each distribution will be treated as an excludable dividend.
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Stock Basis Increase
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The capital gains tax on the sale of stock will be retained. To
ensure that distributions and retentions of previously taxed earnings are treated
similarly, shareholders will be permitted to increase their basis in their shares to
reflect that the retained earnings have already been taxed at the corporate level. As an
alternative to distributing excludable dividends, corporations generally may allocate
throughout the year all or a portion of the EDA to provide these basis increases. The
basis increases will not be taxable. The effect of the basis increases will be to reduce
the capital gains realized when shareholders sell their stock to the extent that the sales
price reflects the corporation's retained, previously taxed earnings.
Allocated basis increases reflecting retained earnings are referred to as REBAs. A
corporation will maintain records of the total REBAs made with respect to its stock in
prior years. The cumulative amount of REBAs for all years is referred to as the CREBA.
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Reporting Requirements
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Under the proposal, shareholders generally will exclude from
gross income, dividends that are characterized as excludable dividends. Each year,
shareholders will receive a Form 1099 from the corporation setting forth which portions of
their distributions are excludable dividends, taxable dividends, or returns of capital. In
addition, the statement will show the amount by which shareholders are entitled to
increase their basis in their stock as a result of REBAs.
Forms 1099 will be revised to provide information to shareholders to indicate the
amounts of excludable dividends, taxable dividends, and returns of capital.
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Elimination of Certain Taxes
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The accumulated earnings tax and personal holding company
tax will be repealed because they are of diminished importance in a system that does not
impose a shareholder level of tax on dividends. Their repeal will simplify compliance with
the tax laws.
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S Corporations
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The S corporation rules will be retained under the proposal with
certain modifications. Under current law, the income of S corporations is subject to an
entity level tax only in limited circumstances. To the extent an S corporation pays income
tax at the corporate level, the S corporation will compute EDA based on that tax and the
income subject to that tax will not be taxed again at the shareholder level.
In addition, under the proposal, distributions first will be treated as excludable
dividends to the extent that the corporation's EDA does not exceed its earnings and
profits and then will be from CREBA.
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No Effect on AMT
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The proposal does not affect the alternative minimum tax
(“AMT”). Excludable dividends will not be an AMT adjustment or preference. In
addition, excludable dividends will not be a preference for adjusted current earnings for
corporate AMT.
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Foreign Shareholders
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In the case of foreign shareholders, the withholding tax on
dividends will be retained for distributions out of earnings and profits, whether or not
excludable, and will apply to distributions from CREBA. U.S. withholding tax will not
apply to REBAs.
REBAs allocable to stock held by a foreign shareholder will not increase the basis of
the foreign shareholder's stock. Any distributions to a foreign shareholder from CREBA
will not decrease the foreign shareholder's stock basis.
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