FROM THE OFFICE OF PUBLIC AFFAIRS

Background

Under current law, corporate earnings may be subject to two levels of tax: one at the corporate level and one at the shareholder level.  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 again at the shareholder level (at rates as high as 38.6 percent).  If a corporation instead retains earnings, the value of corporate stock generally will increase to reflect the retained earnings.  When shareholders sell their stock, that additional value will be taxed in the form of capital gains (generally at a maximum rate of 20 percent).  The resulting rate of tax on corporate income can be as high as 60 percent, far in excess of tax imposed on other types of income. 

This double taxation of corporate profits creates severe economic distortions.
 
• First, it creates a bias in favor of debt as compared to equity, because payments of interest by the corporation are deductible while returns on equity in the form of dividends are not. Excessive debt increases the risks of bankruptcy during economic downturns. 
• Second, double taxation of corporate profits creates a bias in favor of unincorporated entities (such as partnerships and LLCs) that are not subject to the double tax. 
• Third, double taxation of corporate profits encourages a corporation to retain its earnings rather than distribute the earnings in the form of dividends, distorting investment returns and decisions by lessening the pressure on corporate managers to undertake only the most productive investments. 
• Fourth, double taxation encourages corporations to engage in transactions such as share repurchases rather than paying dividends because they permit the corporation to distribute earnings at reduced capital gains rates. 
• Fifth, double taxation creates incentives for corporations to engage in transactions for the sole purpose of minimizing their tax liability.

The Administration’s Proposal

The Administration's proposal would permit a corporation, public or private, to distribute tax-free dividends to its shareholders to the extent that those dividends are paid out of previously taxed income.  That is, shareholders would be able to exclude the dividends from income tax. The proposal generally would be effective for dividends paid on or after January 1, 2003, with respect to corporate earnings after 2001. 

Computing the Excludable Dividend Amount

To compute the dividends that can be paid to shareholders without tax, a corporation would calculate an excludable dividend amount (EDA).  The Excludable Dividend Amount reflects income of the corporation that has been fully taxed.  The Excludable Dividend Amount is calculated for each calendar year as follows:

(US taxes + foreign tax credits used to offset US tax liability)
.35

- (US taxes + foreign tax credits used to offset US tax liability)

= excludable dividend income.

 
A corporation’s US taxes include the total tax amount reflected on its US federal income tax return filed during the calendar year.

 The proposal also includes a mechanism to ensure that dividends and retained earnings are treated alike.  If a corporation’s excludable dividend amount exceeds the dividend it pays, each shareholder’s basis in its stock would be increased on December 31st by the amount retained per share.

 Corporations paying excludable dividends or that retain a portion of their Excludable Dividend Amount would report to shareholders the amount of Excludable Dividends and basis adjustments annually on IRS Form 1099.

Characterization of Distributions

If an amount is a dividend under current law, it would be treated as an excludable dividend to the extent of the Excludable Dividend Amount. If a corporation’s dividends during a calendar year exceed its Excludable Dividend Amount, only a proportionate amount would be treated as an excludable dividend.  Distributions in excess of the Excludable Dividend Amount generally will reduce basis, constitute a taxable dividend, and/or constitute a capital gain.

US withholding tax would apply to dividends paid by a US corporation to its foreign shareholders.

Refunds of Taxes

If a corporation is entitled to a refund of taxes as a result of an audit adjustment, a net operating loss, a foreign tax credit, a claim for refund, or for other reasons, the refund would be permitted based on the corporation’s undistributed Excludable Dividend Amount in the year of the refund.  Any remaining refund amount would be carried over to subsequent taxable years.

Corporations Permitted to Distribute Excludable Dividends

 
Under the Administration’s proposal any corporation with income subject to US tax could pay excludable dividends.  Foreign corporations that have income that is effectively connected with a US trade or business or that receive excludable dividends also could pay excludable dividends.

Sales of Stock

Capital gains on the sale of stock would continue to be taxed as under current law. Shareholders of a corporation that retains some or all of its Excludable Dividend Amount would be permitted to increase their stock bases.  This adjustment would reduce capital gains recognized on the sale of stock, equalizing the treatment of dividends and retained earnings. 

Special Entities

Under current law, the income of S corporations typically is not subject to corporate tax.  Consequently, the general rules for S corporations would not change.

The Administration’s proposal would permit a mutual fund or a real estate investment trust that receives excludable dividends to pass those excludable dividends through tax free to its shareholders.  Special rules would be provided for excludable dividends received and paid by insurance companies.

Under current law, a corporation is allowed to deduct certain dividends paid with respect to shares held by an Employee Stock Ownership Plan (ESOP) that it sponsors.  Under the Administration’s proposal, special rules would be provided to ensure that a corporation could pay excludable dividends to an ESOP or claim a deduction for the dividends, but not both.

Excludable Dividends Received by Pension Plans, 401(k) Plans, and Individual Retirement Accounts (Retirement Plans)

The Administration’s treatment of Retirement Plans would not change. 

Generally, under current law, amounts contributed to a Retirement Plan are not subject to tax when contributed. Income earned by the Retirement Plan is not subject to tax when earned. Instead, contributions and earnings are subject to tax when distributed. In contrast, contributions to a Roth-IRA are made with after-tax dollars. However, both the after-tax contributions and income earned on those contributions are free from tax when distributed.

 
All investment income, including dividend income, earned by a Roth-IRA is free from tax. The tax treatment of other retirement plans is economically the same as Roth-IRA treatment. A plan with tax-free contributions and no tax until withdrawal produces the same after-tax benefit for an individual as a plan with after-tax contributions and tax-free investment returns. Thus, in a Retirement Plan, all investment income, including all dividend income, is effectively free from tax.

Rules to Prevent Gaming

Current law contains rules that prevent taxpayers from avoiding taxes, double dipping, and creating unintended losses.  Similar rules would be provided for excludable dividends.