FROM THE OFFICE OF PUBLIC AFFAIRS

• When a corporation is taxed on its income and later pays dividends that are taxable to shareholders, this effectively results in the same income being taxed twice.  This double taxation of corporate earnings distorts business decision-making and is inefficient.  To eliminate the distortion and inefficiency, dividends should be excluded from income if the dividend income has been taxed at the corporate level. 

• Not every dollar of what could be paid out in dividends will have been subject to tax at the corporate level, however.  To ensure that dividend income is taxed once, but only once, either at the corporate or shareholder level, the dividend exclusion includes a mechanism – an excludable dividend account – for determining whether the dividend has been subject to tax at the corporate level.  (A similar mechanism exists under current law.  Distributions are treated as dividends only to the extent the corporation has earnings and profits (E&P).  Distributions exceeding E&P are treated first as a return of the taxpayer’s investment in the stock and then, to the extent the distribution exceeds that investment, as capital gain on the stock.)

• An excludable dividend account (EDA) is the mechanism that would determine the amount of income that has been fully taxed at the corporate level and, thus, the amount of distributions that would not be taxable to shareholders.  If the corporation made distributions that exceeded the EDA, the excess distributions would be a taxable dividend to shareholders (or a return of the shareholders’ investment).

• Use of EDAs represents a policy decision that income should be taxed once (but only once) at some level (corporate or individual) and not escape the system entirely free of tax. 

• Particularly because of the attention given to tax shelters, it is important to understand that only income that has been fully subject to tax is eligible for the dividend exclusion. 

• EDAs are computed using a relatively simple arithmetic formula to compute the amount of excludable dividends.