The Journal of The DuPage County Bar Association

Back Issues > Vol. 15 (2002-03)

Elimination Of the Double Taxation On Corporate Dividends
By Amy J. Wenz

Under the current tax law, corporate earnings are taxed twice: first when earned by the corporation,1 and a second time when distributed to the corporation’s individual shareholders in the form of dividends.2 At the start of 2003, the Bush administration unveiled its budget proposal for the coming fiscal year, including a revamped tax on corporate dividends. If enacted, the proposal would exclude from the gross income of shareholders dividends received out of previously taxed corporate earnings. The proposal is estimated to provide $386 billion in tax cuts over the next ten years.3

Much is being written in the tax press about who will benefit if the President’s proposal to eliminate the double taxation of corporate earnings is enacted.4 This article seeks to explain the current proposal and the rationale advanced by its proponents, together with some of the criticisms of the proposal, so that readers may reach their own conclusions on the merits of the proposed tax cut.

I. Proposal

A. Reasons For Change

In its January 21, 2003, explanation of the proposal, the Treasury Department advanced the following reasons to eliminate the second layer of tax on corporate dividends:

• First, double taxation 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 and retained earnings 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 limited liability companies), which are not subject to the double tax.

• Third, because dividends are taxed at a higher rate than are capital gains, double taxation of corporate profits encourages a corporation to retain its earnings rather than distribute them in the form of dividends. This lessens the pressure on corporate managers to undertake only the most productive investments because corporate investments funded by retained earnings may receive less scrutiny than investments funded by outside equity or debt financing.

• Fourth, double taxation encourages corporations to engage in transactions such as share repurchases rather than to pay dividends because share repurchases permit the corporation to distribute earnings at reduced capital gains tax rates.

• Fifth, double taxation increases incentives for corporations to engage in transactions for the sole purpose of minimizing their tax liability.5

B. Proposed Legislation

The Jobs and Growth Tax Act of 2003 (the "Act"), introduced in both the House of Representatives and in the Senate on February 23, 2003, contains, among other provisions, the specific statutory language designed to implement the President’s proposal.6 What follows is a summary of the dividend exclusion sections of the Act.7

Under the Act, corporations continue to calculate and pay tax under current rules, including the existing graduated rate schedule. The corporate alternative minimum tax rules also would continue to apply. The current rules under which corporations determine earnings and profits are also retained. Corporations would still be permitted to file consolidated returns, consistent with current law.

Because the dividend exclusion is limited to previously taxed corporate earnings, the "excludable dividend amount" ("EDA") for each calendar year is the key component of the proposal. The EDA is designed to reflect corporate earnings that have been fully taxed at the corporate level. It is the EDA that can then be distributed to shareholders as tax-free dividends. Generally, a corporation with $100 of taxable income will pay $35 in corporate income tax and the EDA will be $65. Although graduated tax rates continue to apply for purposes of determining corporate tax liability, the EDA is calculated as if all income is taxed at the 35 percent rate. The corporation then adds to EDA dividends that the corporation received in the prior year and excluded from its income under this dividend exclusion. In addition, "retained earnings basis adjustments," described below, would also be added to the EDA. The addition of dividends received and retained earnings basis adjustments ensures that in the context of tiered corporations, income previously taxed at the level of a lower tier corporation is not taxed again at the level of a higher tier corporation.

At the start of each year, a corporation will have sufficient information to calculate its EDA for the year. In calculating EDA for a calendar year, the relevant corporate tax paid is the tax shown to be due on the corporation’s tax return filed in the previous calendar year. This results in a two year delay between taxable income and the EDA with respect to such income. For example, in determining EDA for 2006, the relevant income tax used in the calculation is that tax shown on the corporate return filed, assuming an extension, on September 15, 2005, with respect to income earned in 2004. In addition to the taxes shown to be due on the return filed in the prior year, EDA is also increased to the extent that taxes were paid in the prior year with respect to earlier periods, such as taxes paid as a result of an assessment of deficiency. Special rules apply for corporations with taxable years other than the calendar year.

Dividends paid by such a corporation, up to the amount of EDA, will be received by shareholders tax-free. This is true for both individual and corporate shareholders.8 If the applicable EDA for the year exceeds the amount of dividends distributed, then a corporation will have the alternative of increasing the basis of the corporation’s stock in the hands of its shareholders. Essentially, a corporation would be authorized to declare basis increases out of EDA throughout the year just as it may declare dividends. The purpose of this provision is to provide similar tax-free treatment to retained earnings. The basis increases are not taxable and have the effect of reducing the gain realized when a shareholder sells the stock. These basis adjustments reflecting the corporation’s retained earnings are referred to as "REBAs." Corporations need to keep track of REBAs in prior years, and the aggregate of the REBAs for all prior years is referred to as "CREBA."

The Act would authorize the Secretary to permit, by regulation, carryover of EDA that is not distributed in the form of dividends or utilized to increase the basis in stock to the following year; however, in the absence of such regulations, the EDA is determined annually, generally without carryover to succeeding years. Therefore, unless and until the Secretary exercises this regulatory authority, if the EDA is not distributed as dividends or used to provide REBAs during the calendar year, it would be lost.

For a distribution to qualify as an excludable dividend under the proposal, it must be made out of earnings and profits. If distributions exceed the corporation’s EDA, the Act would provide ordering rules for the treatment of the excess. The excess is treated, first, as a return of basis and then as capital gain to the extent of previous cumulative basis adjustments; second, as a taxable dividend to the extent paid out of the corporation’s earnings and profits; third, as a return of capital to the extent of any remaining basis; and, finally, as capital gain. This will permit a corporation to adopt a consistent dividend payment policy in the face of fluctuating taxable income (and therefore fluctuating EDA) without causing shareholders to pay immediate tax on dividends.

While all of the nuances of the proposal are beyond the scope of this article, it is important to note that additional changes to other tax provisions should be expected to ripple through the tax laws if the proposal is adopted.

C. Current Status of the Proposal

The fate of the dividend exclusion proposal is, of course, uncertain. The proposal to eliminate the double taxation on corporate dividends is part of the larger Jobs and Growth Tax Act of 2003, which also contains provisions that accelerate the reductions of marginal tax rates and several other tax cuts that were part of the tax relief enacted in 2001. The total package is estimated to provide $726 billion in tax relief over then next ten years (or cost $726 billion in tax revenues over the same period, depending on your perspective). Because the President’s budget proposal has the government operating at a deficit, legislators are seeking ways to pass a more balanced budget bill. In the Senate, for example, the fiscal year 2004 budget resolution limits the possible tax cut to $350 billion. The final budget resolution in the House of Representatives, on the other hand, allows for a tax cut up to $550 billion.9 Modifying (or eliminating altogether) the dividend exclusion proposal has been targeted as a way to pass the President’s growth package and stay within the congressional budget resolution limits. In fact, a Senate Finance Committee aide has reportedly confirmed that among the issues under consideration by the Committee is whether to remove the dividend relief from the President’s tax cut proposal.10 Although Treasury Secretary Snow continues to advocate for the Bush Administration’s full dividend exclusion proposal, it has been suggested that the Bush administration accept a 50 percent dividend exclusion as a possible compromise.11

At the writing of this article, the Senate Finance Committee anticipated marking up the bill containing the tax reconciliation package on May 8, 2003.12

II. Pros and Cons

A discussion of the pros and cons begins with the stated goals of the Bush administration as outlined above. In its explanation of the proposal, the Treasury Department stated:

By eliminating double taxation, the proposal will reduce tax-induced distortions that, in the current tax system, encourage firms to use debt rather than equity finance and to adopt noncorporate rather than corporate structures. Because shareholders will be exempt from tax only on distributions of previously taxed corporate income, the proposal will reduce incentives for certain types of corporate tax planning. In addition, the proposal will enhance corporate governance by eliminating the current bias against the payment of dividends. Dividends can provide evidence of a corporation’s underlying financial health and enable investors to evaluate more readily a corporation’s financial condition. This, in turn, increases the accountability of corporate management to its investors.13

Although not cited as an objective by the President’s administration or the Treasury Department, it has been argued that this proposal may provide the necessary disincentive for corporate inversions, which some in Congress have been seeking to prevent.14 In a corporate inversion transaction, a U.S. company with multi-national operations moves its headquarters and changes its place of incorporation to a tax haven, such as Bermuda, while leaving most operations as is. U.S. corporations are taxed in the United States on their worldwide income, while foreign corporations are taxed on income from sources within the United States or connected with a United States business. An inversion transaction provides tax savings for such multinational operations because it permits foreign source income to escape U.S. tax. Corporate inversions have been targeted by a variety of legislative proposals in the last few years.15 As currently drafted, Bush’s proposal would permit U.S. corporations to pay tax-free dividends out of EDA attributable to foreign source income, but foreign corporations would only be permitted to pay tax-free dividends out of income that is connected with its U.S. business or out of dividends that it has received from other corporations and excluded from its income, thus reducing the benefits of inversion transactions.

Not everyone agrees with the Bush administration. It has been pointed out that the cost of the dividend tax repeal is underestimated by lawmakers.16 In a closely-held corporation in which the shareholders are also employees, there is an incentive to pay shareholder-employees large salaries to avoid the double taxation of dividends. The salary is deductible to the corporation so the payment is taxed only once, at the shareholder-employee’s rate, plus associated payroll taxes. After the scheduled individual tax rate reductions take effect, and if the dividend exclusion is enacted, it will no longer make sense for corporations to pay large salaries, the payment of which is subject to Medicare tax. So long as the individual shareholder-employee’s tax rate, including the Medicare tax, is higher than the corporation’s tax rate, the corporation will have an incentive to decrease salary payments to shareholder-employees in favor of dividends, which are not subject to Medicare tax. The corporation pays tax once at the 35 percent rate and the shareholder can exclude the dividend from income, thus providing overall tax savings by avoiding the Medicare tax, further reducing tax revenues.

It has also been asserted that because the dividend exclusion benefits the recipient rather than the corporate payor, corporations may not increase their payments of dividends.17 This is because payments of interest do give rise to corporate deductions, thus encouraging corporations to continue to favor the use of debt to raise capital over equity.

The dividend exclusion proposal is found in the Jobs and Growth Act, but Senate Minority Leader Tom Daschle has stated that "the White House’s plan will add some $1.5 trillion to our nation’s debt, while providing no real benefit to most American families."18 In fact, at least one economic correspondent has argued that the tax cut plan could actually hurt the economy: "Tax cuts that increase the deficit hurt economic growth because the positive effects of a tax cut are usually more than offset by the detrimental effects of a larger deficit."19

Perhaps amidst the pros and cons, a middle ground can be achieved. An economist from the Cato Institute has also suggested alternatives for reducing the double tax on corporate earnings that he argues would be revenue neutral instead of costing $386 billion, the estimated cost of the Bush proposal. For example, the tax rate for dividends could be reduced to the capital gains tax rate, or the first $2,000 of dividends could be exempt from tax. The proponent of these alternatives asserts that this would encourage more companies to pay dividends and encourage taxable investors to hold dividend paying stocks, thereby increasing the tax base.20

This is not the first time that the elimination of the tax on dividends has been discussed. In fact, the current "proposal is largely based on the dividend exclusion prototype" found in a 1992 Treasury Report entitled "Report of the Department of the Treasury on Integration of the Individual and Corporate Tax Systems: Taxing Business Income Once."21 For now, we will have to wait and see if the dividend exclusion stays in the jobs and growth package, and if so, in what form. Even if the proposal is dropped this time around, it will not be the last we hear of it.

1 Section 11(a) of the Internal Revenue Code of 1986, as amended (the "Code").

2 In the case of individuals, Section 1 of the Code imposes tax on the "taxable income" of individuals. Section 63 of the Code defines taxable income as gross income minus allowed deductions. Under Section 61(a)(7) of the Code, gross income includes dividends.

3 General Explanations of the Administration’s Fiscal Year 2004 Revenue Proposals, U.S. Department of the Treasury February 2003, at 151.

4 See, e.g., Private Sector Gathering Steam In Drive to End Dividend Taxes, Daily Tax Rep. (BNA) No. 67 at G-3 (Apr. 8, 2003) (noting a disagreement about whether the proposal will only benefit the wealthiest of taxpayers or will provide benefits to middle-income tax payers).

5 Memorandum from the Treasury Department on the President’s Dividend Exclusion Proposal, Eliminate the Double Taxation of Corporate Earnings (January 21, 2003) (available at For the statement from the Treasury Department’s Office of Public Affairs accompanying the Memorandum, see

6 H.R. 2, 108th Cong. (2003); S. 2, 108th Cong. (2003).

7 Title II of the Act.

8 In the context of a group of corporations filing a consolidated federal income tax return, all dividends paid to another member of the consolidated group will continue to be excluded from income as they are under current law without regard to the EDA rules.

9 Status of Key Tax, Retirement, Accounting, and Budget Issues in Congress, Daily Tax Rep. (BNA) No. 75 (April 18, 2003) at GG-1.

10 Finance Aides See Dropping Dividend Relief As Possible Option in Tax Measure, Aide Says, Daily Tax Rep. (BNA) No. 79 (April 24, 2003) at G-10.

11 Snow Not Keen on 50 Percent Exclusion As Compromise for Dividend Tax Proposal, Daily Tax Rep. (BNA) No. 57 at G-7 (March 25, 2003) (quoting Snow as stating "[t]here’s no principle of taxing it 1.5 times. . . . The principle here is to tax it once and only once.")

12 Katherine M. Stimmel and Nancy Ognanovich, Frist Says Decisions Needed by May 2 on Tax Plan Slated for May 8 Markup, Daily Tax Rep. (BNA) No. 83 (April 30, 2003) at G-10.

13 Memorandum from the Treasury Department on the President’s Dividend Exclusion Proposal, Eliminate the Double Taxation of Corporate Earnings (January 21, 2003) (available at

14 Ken Brewer, International Implications of President Bush’s Dividend Exclusion Proposal, 30 Tax Notes Int’l 65 (2003).

15 See, e.g., Energy Policy Act of 2003, H.R. 6, 108th Cong., Title IV; The American Competitiveness and Corporate Accountability Act of 2002, H.R. 5095, 107th Cong.; Reversing the Expatriation of Profits Offshore Act of 2002, S. 2119, 107th Cong.

16 Michael Calegari, Corporate Tax Minimization Strategies When Dividends Are Exempt, 98 Tax Notes 1247 (2003).

17 Lorence L. Bravenec and Fred Feucht, The Bush Administration’s Proposed Dividends Exclusion, 98 Tax Notes 1251, 1258 (2003).

18 Patti Mohr and Warren Rojas, Lawmakers Introduce Bush Tax Plan, Prepare to ‘Shape’ It, 98 Tax Notes 1297, 1299 (2003) .

19 Martin A. Sullivan, Economic Analysis: A ‘Growth’ Plan With No Growth, 99 Tax Notes 330 (2003).

20 Conservatives Suggest Ways to Trim Cost of Bush’s Dividend Tax Cut, 68 Tax Analysts’ Daily Tax Highlights & Documents 2049, 2050 (2003) (citing comments of the Cato Institute’s Alan Reynolds).

21 Bravenec and Feucht, supra note 17, at 1251 n. 1.

Amy J. Wenz is an associate in the Chicago office of Sidley Austin Brown & Wood. Her practice includes state and federal tax issues in corporate mergers and acquisitions, partnerships, joint ventures, and spin-offs. She has also represented commodities trading funds on a range of tax matters. Ms. Wenz received a B.S. in Business Economics from Miami University and graduated summa cum laude from the University of Illinois College of Law.

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