The President's Proposed Dividend Exclusion April, 2003 Hot Topics [an error occurred while processing this directive] Current Law [an error occurred while processing this directive] 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).

Overview [an error occurred while processing this directive] 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.

Excludable Dividend Amount [an error occurred while processing this directive] 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.

Stock Basis Increase [an error occurred while processing this directive] 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.

Reporting Requirements [an error occurred while processing this directive] 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.

Elimination of Certain Taxes [an error occurred while processing this directive] 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.

S Corporations [an error occurred while processing this directive] 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.

No Effect on AMT [an error occurred while processing this directive] 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.

Foreign Shareholders [an error occurred while processing this directive] 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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© 1995-2004 Robert L. Sommers, attorney-at-law, all rights reserved. This article and internet site provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet® is a registered trademark of Robert L. Sommers.