No—corporations cannot deduct dividends paid to shareholders under federal U.S. tax law.
Dividends are considered a distribution of after-tax profits, not a business expense. This means when a C corporation (the standard corporate form) pays dividends, it gets no tax break for doing so. The money used for dividends has already been taxed at the corporate level, and then it’s taxed again on the shareholder’s personal return. In other words, dividends face double taxation and provide zero deduction to the company.
However, there are nuances and a few special-case exceptions. We’ll explore those, along with how this rule plays out for C corporations vs. S corporations, public vs. private companies, and what alternative strategies exist. Understanding why dividends aren’t deductible—and the consequences of trying to treat them like deductible expenses—is crucial for any business owner or investor. Let’s break down the what, how, where, and why of these dividend deduction rules.
Can Corporations Deduct Dividends? Not a Chance—Here’s Why
Put simply, corporate dividends cannot be deducted from a company’s taxable income. Under U.S. tax code, dividends are defined as payments to shareholders from a corporation’s retained earnings (accumulated profits). These payments are not considered an “ordinary and necessary” cost of doing business. Unlike salaries, rent, or supplies—which companies subtract as deductible expenses to calculate taxable profit—dividends come after profit. They’re a distribution of profit to the owners of the company, not a cost incurred to earn that profit.
Double Taxation of Dividends: This non-deductibility is what creates the well-known double taxation of C corporation income. Here’s how it works:
- A C corporation pays corporate income tax (21% federal rate, as of this writing) on its profits. Say the company earned $1,000,000 in pre-tax profit; it would owe up to $210,000 in corporate tax (ignoring state taxes for now), leaving $790,000 in after-tax profit.
- If the corporation then pays dividends out of that after-tax profit—for example, distributing $500,000 to shareholders—those dividends are taxable income to the shareholders. Shareholders might pay, for instance, a 15% or 20% tax (the typical federal tax rates on qualified dividends) on that money. In our example, a 15% tax means another $75,000 in taxes.
- The corporation cannot deduct the $500,000 paid as dividends. It’s not an expense on the corporate tax return at all. So the company still paid $210,000 in its own taxes. The $500,000 dividend doesn’t reduce that bill one cent.
- Total tax hit on the same $500,000 of corporate earnings: first $105,000 at the company level (the portion of corporate tax attributable to that $500k of profit, at 21%), then $75,000 at the shareholder level. That’s $180,000 of tax on $500,000 of earnings – roughly 36% effective tax. This is the double tax in action.
Why No Deduction? The tax law’s logic is that dividends are a share of profits to owners, not an expense of generating revenue. Paying a dividend doesn’t help you earn more income; it simply passes profits to those who invested in the company. By design, regular corporations are separate tax-paying entities (the corporation is taxed, and then owners are taxed on what they receive). Allowing a deduction for dividends would essentially undercut this system because a corporation could then potentially wipe out its taxable income by paying all profits as “deductible” dividends. Instead, Congress set up the C corp system so that profits are taxed at the corporate level and again if passed to shareholders.
C Corporations vs. S Corporations: It’s important to note this rule primarily concerns C corporations (the traditional corporation subject to corporate income tax). S corporations, on the other hand, usually do not pay corporate income tax at all at the federal level. S corps are pass-through entities: their profits “pass through” to the owners’ personal tax returns and are taxed only once at the individual level. An S corporation typically makes distributions to its shareholders (similar to dividends) to help them pay the taxes on the corporate income or to withdraw profits. But since an S corp itself generally isn’t taxed on income, the concept of deducting a dividend doesn’t apply in the same way—there’s no corporate tax to reduce. In an S corp:
- Profits are taxed to the owners whether or not cash is distributed.
- Distributions of profit from an S corp are usually tax-free to the shareholder (they’re essentially returning already-taxed income or capital), and they are not deductible by the S corp. They don’t need to be, because the S corp had no tax in the first place on that income.
- You won’t see “dividend expense” on an S corporation’s tax return (Form 1120-S). Instead, shareholders get a K-1 form reporting their share of the S corp’s income.
So, for C corps (including most public companies and many private ones): dividends are not deductible, leading to that double taxation scenario. For S corps and other pass-throughs (like LLCs taxed as partnerships): there’s no double corporate tax to begin with, and distributions to owners aren’t deductible but typically aren’t taxed as dividends either.
Public vs. Private Corporations: Publicly traded companies (almost always C corps) often pay dividends to return profits to their many shareholders. They accept that those dividends aren’t deductible; it’s built into their financial planning. Private corporations, especially small businesses, often try to avoid paying dividends because the owner-shareholders don’t want that double tax hit. Instead, they may choose to retain earnings in the company or pay out profits in other ways (such as salaries or bonuses to owner-employees, which are deductible). We’ll discuss those strategies later on. But be aware: if a C corp never pays dividends and accumulates a lot of profit internally, it could face another tax issue (the Accumulated Earnings Tax (AET), more on that soon).
In short, the answer to “can corporations deduct dividends paid?” is a resounding no for standard C corporations. It’s a foundational rule of U.S. taxation. Next, we’ll see exactly how the IRS and the tax code draw the line between a true expense and a dividend, and why misclassifying one as the other can spell trouble.
The IRS Sees It Differently: Why Dividends Aren’t Expenses
From an accounting perspective, a company might feel like dividends are just another way to use its money—so why not treat them like an expense? The IRS, however, sees dividends very differently from deductible business expenses, and the tax code makes that distinction crystal clear.
Dividends vs. Business Expenses: A business expense is something paid to carry on the business and earn income. Think of wages, raw materials, rent, marketing costs—these all help the company produce goods or services and generate revenue. Dividends, on the other hand, are paid to the owners after income has been earned, as a distribution of profit. The Internal Revenue Code (IRC) allows deductions for “ordinary and necessary” expenses of operating a business (under IRC § 162). Paying your electric bill or your employees’ salaries qualifies. Paying your shareholders a return on their investment does not—it’s not “necessary” to pay a dividend in order to run the business (many companies don’t pay dividends at all, especially when growing).
The IRS explicitly disallows treating dividends as expenses. A corporation cannot simply label a payment to a shareholder as some kind of “fee” or “salary” if its real purpose is to distribute profits. The tax regulations state that compensation must be reasonable and “purely for services” to be deductible. If an owner of a company gets paid significantly more than their actual role would justify, the IRS might suspect that the excess is not true salary but rather a hidden dividend.
Constructive Dividends: The term constructive dividend comes up when discussing IRS enforcement. A constructive dividend isn’t officially declared by the board of directors like a regular dividend, but it’s treated as a dividend for tax purposes because it’s essentially a benefit transferred to a shareholder without an offsetting business purpose. For example:
- If a corporation pays a shareholder’s personal expenses (like a luxury car or a vacation) and books it as a “business expense,” the IRS can reclassify that as a constructive dividend. Result: the company loses the deduction (since it’s not a valid business expense) and the shareholder must report income.
- If a company sells assets to a shareholder at below market price or loans them money interest-free, those perks can be constructive dividends.
- If an owner who is also an employee is paid an unreasonably high salary or a “management fee” that doesn’t match actual services provided, the IRS (and courts) may determine the excess is a constructive dividend—again, not deductible for the company.
The IRS’s stance is essentially: you cannot turn a profit distribution into a deductible event by simply calling it something else. The substance over form principle applies. They will look at what actually happened. If the corporation got no tangible business value from a payment (other than maybe keeping a shareholder happy), it’s likely not a true expense.
Salary vs. Dividend – The Fine Line: Especially in closely-held corporations (a small company where one or few shareholders also run the company), there’s a temptation to take money out in the form of salary or bonus, because unlike dividends, salaries are deductible to the corporation. This can reduce or eliminate the corporate tax before profits are distributed. It’s a legitimate strategy—to a point. The IRS expects that any salary paid to a shareholder-employee is reasonable compensation for the work performed. If a small business owner’s corporation makes $500,000 and pays the owner $500,000 in “salary,” leaving $0 corporate profit, that might be okay if the owner is genuinely doing a job worth $500k a year.
But if the business’s success isn’t really due to the owner’s daily labor (maybe they have lots of other employees or capital doing the work) and the owner is just extracting profits, the IRS might say “Hold on, $500k is excessive for that role. Part of that payment is really a dividend.” In that case, the IRS would disallow a portion of the salary deduction for the company (increasing the company’s taxable income) and treat that portion as a dividend to the owner (taxable to the owner as dividend income).
Interest vs. Dividends: Another area the IRS watches is loans from shareholders. If owners capitalize a company with loans instead of stock, the company can pay them interest, and interest is deductible for the corporation (in most cases). Some businesses try to finance with shareholder debt to route profits out as interest (deductible) rather than dividends (not deductible). This too has limits: if the “loan” is too much like equity (for example, no real expectation of repayment, or interest only paid if profits are available), the IRS can re-characterize the “interest” payments as dividends. Additionally, there are thin capitalization rules—if a company is financed with an abnormally high ratio of debt to equity from shareholders, interest deductions might be denied on the grounds the debt is really equity in disguise. In short, the IRS won’t let corporations game the system by simply calling a payment something tax-deductible when it’s effectively a return on ownership.
What the Tax Code Says: There isn’t a single line that says “dividends aren’t deductible” because it’s implicit in how taxable income is defined. Taxable income starts with gross income minus allowable deductions. Nowhere in the list of allowable deductions (IRC §§ 161 and following) will you find dividends. In fact, the tax code has special provisions to prevent certain dividend-related deductions.
For instance, IRC § 246 denies a dividends-received deduction (a special deduction for corporate shareholders receiving dividends, discussed later) if the holding period isn’t met or the situation is tax-avoidance. And IRC § 404(k), while it actually permits a deduction for certain dividends paid to employee stock ownership plan (ESOP) participants, also contains anti-abuse rules to deny deductions if a “dividend” is just a tax dodge.
The bottom line: The IRS views dividends as non-deductible by design, and it has plenty of tools to enforce that. In the next section, we’ll put some of these ideas into concrete numbers with real-world examples, to illustrate the tax outcomes of dividends versus other payouts.
Real-World Tax Scenarios: See the Numbers
Sometimes the easiest way to understand the impact of dividends and their non-deductibility is to walk through examples. Below are a few simplified scenarios comparing dividends to other forms of payouts and different corporate structures. These examples will show the tax results step by step.
Example 1: C Corporation Paying Dividends vs Paying Salary
Imagine TechCo, a C corporation, has one owner who also works as the CEO. TechCo’s profit before any owner compensation is $200,000 this year. The owner has two choices:
- Have the company pay out a $200,000 dividend to herself (as the shareholder).
- Have the company pay her a $200,000 bonus (salary) for her work, leaving no profits for a dividend.
Let’s compare the tax outcomes of these two strategies in a simple two-column table:
| Scenario | Tax Outcome |
|---|---|
| $200,000 Dividend (Not Deductible) | – TechCo pays corporate tax on $200,000 profit first (21% of $200k = $42,000). – After tax, $158,000 is left to distribute as a dividend to the owner. – Owner pays personal tax on the $158,000 dividend. Assuming a 15% dividend tax rate, that’s $23,700 in tax. – Total tax = $42,000 (corp) + $23,700 (owner) = $65,700. The owner keeps $134,300 net. |
| $200,000 Bonus (Deductible) | – TechCo deducts the $200,000 bonus as a business expense, so corporate taxable income becomes $0. The corporation pays $0 in corporate tax. – The owner/CEO reports the $200,000 as wage income. Assuming she’s in, say, a 35% tax bracket for ordinary income, she pays about $70,000 in federal income tax on that salary (wages are taxed at regular income rates). Payroll taxes (Social Security/Medicare) would also apply, but we’ll ignore those for simplicity. – Total tax ≈ $70,000, all borne by the owner as income tax. The owner keeps roughly $130,000 net. |
In this example, paying a dividend resulted in a total tax bill of $65,700, while paying the bonus salary resulted in about $70,000 in tax. The dividend was slightly more tax-efficient for this particular set of assumptions because the owner’s individual tax bracket (35%) was much higher than the dividend tax rate (15%). However, note that the company had to pay its share first in the dividend scenario. If the owner had been in the top dividend tax bracket (20% + a possible 3.8% net investment tax) the gap would narrow. And if the owner’s salary was deductible, the corporation could even push itself into a loss to carry forward, etc. There are many variables, but the key takeaway is: dividends shift part of the tax to the corporate level, while salaries shift all tax to the individual level. A corporation can’t deduct the dividend, so it inevitably pays some tax on those earnings.
Example 2: C Corp vs. S Corp – Taxation of $100 Profit
Let’s compare how double taxation vs. pass-through taxation impacts the take-home from $100 in profit. BizCorp is a C corp and Flow-Through Inc is an S corp; each earned $100 pre-tax profit. Both are 100% owned by a single shareholder in the 20% income tax bracket. The table below shows the outcome for each:
| C Corporation (double taxed) | S Corporation (pass-through) |
|---|---|
| Corporate tax: Pays $21 (21% of $100) in federal corporate tax. $79 profit left after tax. Dividend: Pays remaining $79 to owner as a dividend. Shareholder tax: Owner pays $11.85 tax (15% of $79 dividend). Total tax: $32.85 (both levels combined). Net to owner: $67.15 (after all taxes, from the original $100 profit). | Corporate tax: Pays $0 (no entity-level tax for S corp). Entire $100 is allocated to owner’s income. Distribution: Owner takes, say, $100 distribution (optional, but usually done to provide cash for taxes or personal use). Shareholder tax: Owner pays $20 tax (20% of $100 pass-through income). The distribution itself isn’t taxed. Total tax: $20 (one level, at owner’s rate). Net to owner: $80 (after tax on $100 profit). |
This simple example highlights why many small businesses avoid C corporation status. The S corporation in this scenario allowed $80 net to the owner on $100 profit, whereas the C corporation left the owner with about $67.15 net on the same $100 economic profit after paying a dividend. The C corp’s inability to deduct the dividend meant Uncle Sam took a cut at two levels. The S corp route resulted in a single level of tax. (For fairness, note that if the owner were in a higher individual tax bracket, the S corp tax could be higher than 20%. But generally, pass-through taxation avoids the extra 21% corporate layer.)
Example 3: Disguising a Dividend as an Expense – A Risky Move
Consider ABC Corp, a closely-held C corporation with three shareholders who also manage the business. ABC Corp had a very good year, with $300,000 in pre-tax profits. Rather than report $300k in profit and possibly pay corporate tax on it (and then dividends), the owners decide to pay themselves each a “management fee” of $100,000 at year-end, leaving the books with $0 profit. On paper, it looks like ABC Corp has zero taxable income after deducting $300k of management fees – a neat trick to avoid corporate tax, right?
But here’s the catch: suppose these three shareholders didn’t actually perform $300,000 worth of extra services. Maybe they each already took a salary earlier in the year, and the $100k each is a last-minute decision when the accountant said the company had big profits. If the IRS audits ABC Corp, it might recharacterize those “management fees” as non-deductible dividends (in tax terms, constructive dividends), on the grounds that they were not reasonable compensation for services but rather payouts of profit. Let’s see the outcomes:
| “Fee Deduction” Plan (what owners hoped) | Reclassified as Dividend (IRS outcome) |
|---|---|
| Corp taxable income & tax: $0 taxable (all profits offset by “fees”), so $0 corporate tax. Owners’ tax: Each owner pays normal income tax on $100k compensation. If 32% bracket, that’s $32k each (total $96k tax for all three). Combined tax: $96k overall (company + individuals). | Corp taxable income & tax: $300,000 taxable income (fees disallowed), so $63,000 corporate tax (21%). Owners’ tax: Each owner’s $100k is now a dividend. At 15% rate, $15k tax each (total $45k for three). Combined tax: $108k overall. Plus potential penalties/interest for the improper deduction. |
In the “reclassified” scenario, not only does the IRS collect more tax ($108k vs $96k) because the dividend route ended up a bit worse here, but ABC Corp and its owners could face penalties and interest for underpaying taxes and mischaracterizing the payments. The IRS essentially says: “Nice try, but those payments were disguised dividends – you can’t just deduct them. Pay up.”
The lesson from this scenario is clear: Trying to disguise dividends as expenses can backfire badly. The tax savings you think you’re getting can evaporate, and you might end up paying more, along with fines. Courts have consistently upheld the IRS’s authority to deny deductions in such cases, as we’ll touch on later.
These examples show in numbers why dividends are treated differently and how the taxes can add up. Next, let’s look at common pitfalls and mistakes related to dividends that can draw unwanted attention from the IRS.
Red Flags: Mistakes That Trigger IRS Scrutiny
With the tax stakes high, corporations and shareholders sometimes push the envelope in handling dividends and payments to owners. Here are some common mistakes and red flags to avoid:
- 🚩 Treating a Distribution as a Deductible Expense: As shown above, labeling a payment to a shareholder as a “fee,” “rent,” or other expense when it’s really a way to pull out profits is a big no-no. The IRS is adept at spotting constructive dividends. If your company has healthy profits but no corresponding expenses to explain payments to shareholders, expect questions. Always ensure payments to owner-employees are for real services or legitimate bills, with documentation.
- 🚩 Skipping Reasonable Salaries (S Corp Trap): In an S corporation, owners might be tempted to take all the profit out as distributions (which aren’t hit with payroll taxes) and pay themselves little to nothing as W-2 salary. The IRS knows this game. It requires reasonable compensation for shareholder-employees of S corps. If you’re an S corp owner-operator and take, say, $0 salary on $250,000 of profit (all as distributions), you’re waving a red flag. The IRS can reclassify some of those distributions as wages, hitting you with back payroll taxes and penalties. Balance your salary and distributions in an S corp; make the salary part reflect the value of the work you do.
- 🚩 Overpaying Shareholder-Employees (C Corp Trap): Conversely, in a C corp, paying huge salaries or bonuses to owner-shareholders to wipe out income can draw scrutiny. The IRS might ask, “Would you pay that much to an outsider for the same job?” If not, the excess could be deemed a disguised dividend. Ensure that any compensation to owners is in line with their role, credentials, and what similar companies would pay for similar services. Document responsibilities and time spent to justify the pay.
- 🚩 Not Issuing 1099-DIV Forms: Corporations (C corps) that do pay dividends must report them to both the shareholder and the IRS (using Form 1099-DIV) if the total is $10 or more. Failing to issue required 1099-DIV forms is a compliance mistake that can trigger IRS attention. It might signal that dividends were paid “under the table” or that the company is disorganized. Always properly record and report dividend payments.
- 🚩 Accumulating Excessive Earnings to Avoid Tax: Some profitable C corporations try to hoard earnings instead of paying dividends, thinking they’ll indefinitely defer the shareholder-level tax. While retaining earnings for growth, expansion, or a cash cushion is fine, there’s a penalty tax if the accumulation is beyond reasonable business needs. The Accumulated Earnings Tax (AET) is a hefty 20% surtax on profits unduly retained (generally beyond $250,000 for regular C corps, or $150,000 for certain service corporations). If your company never pays dividends and piles up cash without a solid purpose (like planned expansion, R&D, etc.), the IRS might impose this tax. To avoid AET, document why the company needs to retain earnings (e.g. future projects, contingencies) or consider paying at least some dividends over time.
- 🚩 Mixing Personal and Corporate Funds: Using corporate funds for a shareholder’s personal benefit (outside of a formal dividend or salary) is a classic error. For example, if the corporation is paying the owner’s home mortgage or personal travel and calling it a business expense, it’s usually taxable to the owner as a constructive dividend (and non-deductible to the company). Keep business and personal finances separate to avoid inadvertent dividends and lost deductions.
- 🚩 Ignoring State Tax Implications: Sometimes a strategy that saves federal taxes (like certain distributions or compensations) can have different consequences at the state level. We’ll cover state nuances later, but failing to consider state corporate tax rules or personal income tax on dividends can be a mistake. For instance, some states don’t recognize S corp status and still tax the corporation, or they might have their own version of an accumulated earnings tax or limits on deducting certain payments.
In short, transparency and substance are key. If profit is going from the company’s coffers to a shareholder’s pocket, the IRS expects it to be reported in the correct form (dividend, salary, etc.) and will scrutinize any creative efforts to disguise that movement. The best practice is simple: follow the rules, and don’t try to make a dividend something it isn’t. Next, we’ll explore alternatives and planning strategies—what corporations can do with their profits if paying dividends has downsides.
Better Options? Comparing Dividends, Salaries, and Retained Profits
If dividends aren’t deductible and can lead to double taxation, what other strategies can corporations use to allocate profits? Here we compare three common paths for profit allocation: paying dividends, retaining earnings, and paying owner compensation (salaries/bonuses). Each has pros and cons, and the best choice can depend on the company’s goals and shareholders’ situations.
First, here’s a quick comparison table outlining the pros and cons of using dividends versus retaining the earnings in the company or paying them out as compensation:
| Strategy | Pros | Cons |
|---|---|---|
| Pay Dividends to Shareholders | – Rewards owners/investors with immediate returns (income now). – Sends a positive signal of company profitability and stability (especially for public companies, regular dividends can attract investors). – Dividend income is taxed at a favorable rate for individuals (generally 15% or 20% for qualified dividends, which is lower than top ordinary income rates). | – Double taxation: profits taxed at corporate level and again as dividend income to shareholders. – Not deductible for the corporation, so no tax relief on the payout. – Cash outflow from the company, which could otherwise be reinvested into growth or kept as a safety net. |
| Retain Earnings in the Company | – Funds available to reinvest in business expansion, R&D, acquisitions, or to weather downturns. – Avoids immediate second layer of tax (shareholders aren’t taxed until they sell stock or the company eventually pays dividends). – Increases company equity (which can boost creditworthiness and share value). | – Shareholders may be unhappy receiving no immediate returns, especially if they rely on investment income. – Could attract IRS scrutiny if hoarded just to dodge shareholder taxes (risk of Accumulated Earnings Tax if beyond reasonable needs). – Shareholders ultimately face tax when they realize gains (either via a future dividend or selling stock, potentially as a capital gain). – For public companies, too much cash with no dividends could invite pressure from investors or even activist takeover attempts. |
| Pay Out as Salaries/Bonuses (Compensation) | – Deductible for corporation, reducing or even eliminating corporate taxable income (no first-layer corporate tax if done right). – Puts money in owners’ hands in a form that avoids the dividend double tax. – Compensation can be tied to effort and performance, which feels fair to owner-managers working in the business. – Wages received allow contributions to retirement plans (401(k), etc.) and accrue Social Security benefits, which dividends do not. | – Can trigger IRS limits: compensation must be “reasonable” for the work done, or excess gets reclassified as non-deductible dividend. – Subject to payroll taxes (Social Security and Medicare), which dividends aren’t. This can be around 15.3% on wages up to certain limits (split between employee and employer). – Owners in high personal tax brackets might pay more tax on wages than they would on dividends (since top ordinary rate 37% vs top dividend rate 20%). – For C corps, paying out all profit as salary leaves nothing to reinvest in growth (not always desirable if the company needs capital to expand). |
As you can see, each approach has its advantages and drawbacks. Often, companies use a mix: pay some salary, maybe a modest dividend, and retain some earnings. The optimal balance can depend on the corporate structure and the shareholders’ needs:
- Public C Corporations typically do either dividends or share buybacks with excess profits. They usually don’t use “salaries” as a mechanism to distribute profits (since most shareholders aren’t employees). If anything, they might increase executive compensation, but that’s not usually to pass out profits, it’s more tied to performance. Public companies also keep significant retained earnings to fund growth, but many will pay dividends to keep investors happy and share price attractive.
- Private C Corporations (closely held) might lean toward the salary/bonus route for owner-employees to minimize corporate taxes (within reason), and perhaps retain earnings for expansion. They often avoid dividends if the owners can get money out via deductible ways. But if there are passive investors or shareholders who don’t work in the business, the company might need to issue dividends to give those owners a return, since paying them a salary isn’t an option.
- S Corporations by design are set up to avoid the double tax. The common practice is to pay the owner-employees a reasonable salary (so that the IRS is satisfied and payroll taxes are paid on that portion), and then distribute the remaining profit as dividends (actually distributions) which aren’t subject to a second tax at distribution. Essentially, S corp owners get the best of both: profits taxed once, and they can still withdraw the money. The tension is making sure salary vs distribution is balanced to appease the IRS and maximize tax efficiency.
Retained Earnings vs. Payouts: Another strategic consideration is the company’s lifecycle and goals. A startup or growth company will often retain earnings to fuel rapid expansion — it likely won’t pay dividends at all. That’s not about taxes, it’s about business need. Mature, stable companies (think utilities or large consumer goods firms) often generate more cash than they can reinvest efficiently, so they return it to shareholders as dividends or stock buybacks. For them, the double taxation is just part of the equation of being a C corp, and they manage it through things like the lower qualified dividend tax rates and sometimes by targeting investors who appreciate dividends (like retirees or funds that don’t pay tax, e.g., pension funds or endowments).
Bonuses and Timing: One tactic for closely-held C corps is the year-end bonus: paying key owners/employees a large bonus to essentially distribute profit in a deductible way. This can work, but remember the “reasonable” rule: the bonus should reward actual performance or duties. The IRS might scrutinize a bonus that’s, say, 10 times someone’s normal salary with no clear reason other than wiping out profit.
Alternate Paths – Interest, Rent, etc.: Some owners use other mechanisms to get money out of a corporation in deductible ways. For example, a shareholder might loan money to their corporation and then the corporation pays interest (deductible) to the shareholder. Or a shareholder might lease property to the corporation and the corporation pays rent (deductible) to the shareholder. These strategies can be legitimate too—but like salaries, the amounts have to be reasonable and at fair market rates. If you charge an excessive rent or interest rate just to siphon profits, the IRS can step in and recharacterize the excess as a dividend or disallow it.
The main message here is that while corporations cannot deduct dividends, they have other options to consider. Each option must be used properly and legally to avoid the traps we discussed. Often, consulting with a tax advisor to plan the mix of salary, dividends, and retained earnings is wise, as the best solution is case-specific.
Need-to-Know Terms That Make or Break Tax Plans
Understanding a few key tax concepts can make all the difference in planning around dividend issues. Here are some critical terms (in plain English) that come up in this context:
- Double Taxation: In the context of corporations, double taxation refers to income being taxed twice – first at the corporate level and then again at the shareholder level when profits are distributed as dividends. This is a hallmark of C corporations and why dividend planning is important.
- Pass-Through Entity: A business (like an S corporation, partnership, or LLC taxed as a partnership) that doesn’t pay entity-level income tax. Instead, profits pass through to the owners’ personal tax returns. Pass-throughs avoid the double taxation issue since there’s generally only one layer of tax. Dividends per se aren’t a concept for these entities; distributions are not taxed separately from the profit itself.
- Retained Earnings: The accumulation of a corporation’s after-tax profits that have not been distributed to shareholders. These earnings are kept in the company for reinvestment or to strengthen the balance sheet. You’ll see retained earnings on the equity section of a company’s balance sheet. If retained earnings grow too large relative to the business needs (especially in a C corp), it could raise questions (see Accumulated Earnings Tax).
- Accumulated Earnings Tax (AET): A special 20% penalty tax on corporations that retain earnings beyond the reasonable needs of the business to avoid paying dividends (and thus avoid giving shareholders taxable income). Essentially, if a C corp’s retained earnings exceed $250,000 without a good business reason (or $150,000 for professional service corporations), the IRS may impose this tax on the excess to encourage the company to either pay dividends or otherwise justify its cash hoard. There are many exceptions and defenses (like demonstrating plans for expansion, etc.), but it’s a prod to prevent indefinite tax deferral at the shareholder level.
- Dividends Received Deduction (DRD): A deduction that corporations (not individuals) can claim on dividends they receive from other corporations. If a corporation (say Company A) owns shares in Company B and gets a dividend, Company A can often deduct 50% or more of that dividend from its taxable income. This is to avoid multiple layers of corporate tax in corporate-on-corporate investments (it’s not about the individual shareholder level). The DRD percentage is typically 50%, 65%, or 100% of the dividend, depending on how much of the paying company is owned. Keep in mind, this deduction is for the recipient corporation, not the one paying the dividend.
- Dividends Paid Deduction: A term usually referring to the deduction allowed to certain special corporations like REITs (Real Estate Investment Trusts) and RICs (Regulated Investment Companies, e.g., mutual funds) for dividends they distribute. These entities are required to distribute most of their income to investors and are granted a deduction for those dividends, meaning they often pay little to no corporate income tax if they pass earnings out. This is an exception to the normal rule. For instance, a REIT that distributes at least 90% of its taxable income as dividends can deduct those payouts, essentially making it a pass-through entity for tax purposes. Ordinary C corps do not get this deduction, only these special types do.
- Constructive Dividend: As discussed, a constructive dividend is an economic benefit given to a shareholder that’s not formally declared as a dividend but is treated as one by the IRS. It could be free use of company property, excessive compensation, bargain sales, or payment of personal expenses. Constructive dividends are taxable to the shareholder and not deductible by the corporation, just like a regular dividend.
- Reasonable Compensation: A standard that applies mainly in two scenarios: (1) For C corps, to ensure salaries/bonuses to insiders aren’t veiled dividends. (2) For S corps, to ensure owner-employees pay themselves a fair wage and don’t funnel all income out as distributions. There’s no formula in the tax law – it’s based on what similar companies would pay for similar duties. Factors include role and responsibilities, time devoted, experience, and how the company performs. Unreasonable compensation levels can lead to reclassification (to dividends or, in S corp cases, to wages).
- Qualified Dividend: A type of dividend that meets certain IRS criteria (generally U.S. companies, held for a certain period, etc.) and is taxed at the lower capital gains tax rates for individuals (0%, 15%, or 20% depending on your tax bracket, plus possibly a 3.8% net investment income tax for high earners). Most normal dividends from U.S. corporations are “qualified.” Non-qualified dividends (like those from certain foreign companies or REIT payouts that are considered ordinary income) are taxed at regular income rates. We mention this because the double taxation bite is mitigated somewhat by the fact that dividends often get this lower tax rate at the individual level.
- Tax Court (and Courts in general): In the context of our discussion, the U.S. Tax Court and other courts have jurisdiction over tax disputes. If a corporation disputes an IRS finding (say, the IRS says “that was a constructive dividend, pay more tax” and the corporation/owner disagrees), it can end up in court. Over the years, courts have built up a body of case law (precedents) on all these issues: what counts as a dividend, what counts as reasonable comp, etc. Understanding that background can help companies avoid strategies that are known losers.
Knowing these terms arms you with the vocabulary to navigate discussions on corporate distributions and tax. Next, let’s briefly step into the courtroom to see how these concepts play out when companies push the limits.
Courtroom Smackdowns: What Judges Say About Dividend Deductions
Tax law isn’t just statutes and regulations—it’s also shaped by court decisions when taxpayers and the IRS clash. The principle that corporations cannot deduct dividends is so fundamental that few companies openly challenge it. But where we see court battles is in the gray areas—was a particular payment truly a salary or was it a dividend? Was an expense legitimate or just benefiting a shareholder?
One recent example is the Tax Court case Aspro, Inc. v. Commissioner (T.C. Memo 2021-8). In this case, a corporation paid large “management fees” to its three shareholder-owners each year, and conveniently ended up with almost no taxable profit after those payments. The company had never paid formal dividends in its history. The IRS challenged the deductions for those fees, arguing they were in reality disguised dividends. The Tax Court agreed with the IRS. The judge looked at various factors:
- The corporation had plenty of profit but chose not to give any true dividends to shareholders, which was suspicious.
- The “management fees” were roughly in proportion to ownership percentages (each owner got a fee aligned with how much stock they owned, not necessarily how much work each did).
- The fees were decided after year-end, seemingly based on how much money was left over, rather than a pre-determined compensation plan.
- There was no clear documentation of extra services performed to justify those large payments beyond normal salaries.
The court concluded that these payments were not “purely for services” (using the language from the tax regulations on deductible compensation). Therefore, they were not legitimate business expenses. They were essentially a way to zero out earnings – i.e., profit distributions (dividends) by another name. The result: the corporation had to add those amounts back as income (owing corporate tax on them), and the “fees” to shareholders were recharacterized as dividends (taxable to the owners, but no deduction to the company). The court even noted one of the company’s own board members admitted a dividend is “a distribution of profits” whereas a management fee in their view was “a distribution that’s not taxed at the company level” – basically admitting the scheme.
This case wasn’t novel; it was a clear application of long-standing precedent. Over the years, courts have consistently ruled that if a payment to a shareholder is not reasonable compensation or a true expense, it can be deemed a dividend. For instance:
- There have been cases where corporations tried to deduct personal expenses of owners (like the classic yacht or vacation home scenario) as business costs – courts reclassified those as shareholder dividends or simply disallowed them as not legitimate expenses.
- In some instances, interest payments on loans from shareholders have been recharacterized as equity dividends, particularly if the “loan” looked more like stock (e.g., very subordinated, no fixed maturity, etc.).
- Older cases established the doctrine that the label you give a transaction isn’t conclusive – the IRS and courts will look at the substance. If it quacks like a dividend, it’s a dividend, regardless of the name on the check.
Courts have also weighed in on the Accumulated Earnings Tax. To impose that, the IRS has to show a company retained earnings to avoid tax. Companies can defend themselves by showing valid business reasons for the cash. Various Tax Court decisions have parsed what counts as a valid need (say, a plan to purchase new facilities, expected expenses, etc.) versus just excuses. If the court finds a corporation unreasonably withheld dividends just to let shareholders avoid taxes, it will uphold the AET and that’s another smackdown – a 20% penalty tax.
The big takeaway from the courtroom is that judges generally side with the principle that you cannot escape the no-deduction rule through gimmicks. They enforce the idea that a dividend is not a deductible expense, whether you call it a dividend or not. Companies that have been caught usually not only end up paying the taxes they tried to avoid but often also interest and penalties for the trouble.
For everyday planning, this means it’s wise to follow the spirit of the law. If you want to reward shareholders who are employees, pay them reasonable salaries or bonuses. If you want to extract profit and you’re not working for the company, the proper (if not tax-favored) way is via dividends. If you try to blur the lines, the IRS and courts have a track record of sorting it out, often painfully for the taxpayer.
State-Level Curveballs: Tax Rules That Vary by Region
While federal tax law governs whether dividends are deductible (and it uniformly says no), state tax laws can add another layer of complexity to the picture. Here are some state-level considerations regarding corporate income and dividends:
- State Corporate Income Tax: Most states impose their own corporate income tax, and they generally start with federal taxable income as the baseline. Since federal taxable income already excludes dividends paid (because they weren’t deductible federally), states typically also do not allow any deduction for dividends. In other words, you’re not going to escape the non-deductibility of dividends at the state level either. If your C corporation pays dividends, it won’t reduce your state taxable income in most states.
- State Tax on Shareholders: If you live in a state that taxes personal income, you’ll likely pay state income tax on dividends you receive, on top of the federal tax. For example, a shareholder in California will pay state tax up to 13.3% on dividends (since California taxes dividends as ordinary income, not giving them a special rate). Some states, however, have lower or zero taxes on dividend income:
- States like Texas, Florida, and Nevada have no personal income tax, so a shareholder in those states wouldn’t owe state tax on dividends at all (though the corporation, if operating in those states, might still pay franchise or margin taxes).
- A few states treat capital gains or dividends preferentially (for instance, some have exclusions or credits for certain dividends, or like New Hampshire historically had a tax on interest/dividends but is phasing it out).
- Different Treatment of S Corporations: Many states recognize the federal S corporation status and similarly do not tax S corp income at the entity level. But some states are curveballs here:
- New York City, for example, does not recognize S corp status and will tax an S corporation like a C corp for city tax purposes.
- New Jersey historically required an S corp to pay a small fee or minimum tax.
- California allows S corporations but imposes a 1.5% franchise tax on their net income (so an S corp in CA pays 1.5% to the state on profits even though it’s pass-through federally; still much lower than the 8.84% standard CA corporate tax).
- State Accumulated Earnings and Personal Holding Company Considerations: A few states have their own version of certain federal taxes. For instance, if a state bases its corporate tax on federal taxable income, and if your company paid an accumulated earnings tax federally, the effect could carry into state (though many states would allow you to deduct that as an expense, since it’s a federal tax – state rules vary). Generally, state corporate taxes don’t have explicit accumulated earnings taxes, but they rely on the fact that if you paid more federal tax, you likely had more federal taxable income.
- Credits and Deductions for Inter-corporate Dividends: Just like the federal DRD, states often have provisions for corporate dividends received. If your corporation receives dividends from another corp, many states let you deduct some or all of those to avoid triple taxation at the state level. For example, some states allow a 100% deduction for dividends received from affiliated companies. This matters for holding company structures operating in multiple states.
- Franchise Taxes and Gross Receipts Taxes: Not all state business taxes are income taxes. Some states levy franchise taxes (based on capital or net worth) or gross receipts taxes. For instance, Ohio has the CAT (Commercial Activity Tax) on gross receipts, and Washington has a B&O (Business & Occupation) tax on gross revenue. For those taxes, it doesn’t matter if a payment is a dividend or salary or expense – they’re on gross revenue before any deductions at all. So the concept of deducting dividends is irrelevant in such systems, but it also means you can’t deduct other expenses either. Luckily, those taxes usually have lower rates.
- State-level Incentives: Occasionally, states may offer incentives like credits or exemptions to encourage certain businesses or investments. While not common, a state could, for example, give a partial credit to individual investors for dividend income from in-state companies to encourage local investment. Or a state might allow an insurance company a deduction for dividends to policyholders (if structured that way) or other peculiar rules. These are outliers and industry-specific, but a savvy tax planner will check the specific state laws relevant to the corporation’s operations and the shareholders’ residences.
In summary, state taxes won’t overturn the fundamental rule that dividends aren’t deductible, but they can change the effective tax cost of paying dividends (making them higher or lower) depending on local tax rates and rules. A company operating in multiple states also has to consider where its income is taxed versus where its owners are taxed. In some cases, an owner might pay state tax on a dividend in their home state even if the corporation already paid tax on that income in another state – there’s no direct mechanism like the federal DRD for individuals, though they might get some credit for out-of-state taxes in certain situations.
The key is to not ignore state and local taxes when making decisions about dividends and distributions. What looks wise on a federal level could have different implications when state taxes are layered in. Consulting a tax professional who understands the specific state rules is often prudent, especially for larger distributions.
FAQs: Straight Answers to Common Questions
Q: Why can’t corporations write off dividends like other expenses?
A: Because dividends are seen as sharing profits with owners, not a cost of earning income. They come from after-tax profits, so tax law doesn’t count them as a business expense eligible for deduction.
Q: Are there any tricks to make dividends deductible?
A: Not really for regular C corps. Any “trick” (like disguising dividends as salary or fees) can be reclassified by the IRS. Only special entities (like REITs or ESOP plans) get genuine dividend deductions by law.
Q: Do S corporations have dividends?
A: S corps don’t generally pay “dividends” in the legal sense. They make distributions of profit to shareholders. Those aren’t taxed as dividends, and the S corp can’t deduct them—but it doesn’t need to.
Q: How can I avoid double taxation on my company’s profits?
A: Use a pass-through structure (e.g. S corp or LLC) so income is taxed once at owner level. Or pay profits out as deductible expenses (like salaries) instead of dividends.
Q: What happens if my corporation mistakenly deducts a dividend?
A: The IRS will disallow it. The company will owe back taxes (plus interest and penalties) since dividends aren’t deductible. Shareholders may need to amend their returns to report the dividend income.
Q: Is it better to pay dividends or higher salaries to reduce taxes?
A: Usually, yes: a reasonable salary to an owner (deductible to the company) can cut total tax. But salary faces higher individual rates and payroll taxes, so a balanced approach is best.
Q: Does retaining earnings avoid taxes?
A: Only defers the shareholder’s tax; the corporation still pays tax on those profits. If you stockpile too much profit without a good business reason, the IRS may impose an extra accumulated earnings tax.
Q: I heard about an “ESOP dividend deduction.” What’s that?
A: C corporations with Employee Stock Ownership Plans (ESOPs) can deduct certain dividends paid on ESOP-held stock, if those dividends are passed to plan participants or used to repay an ESOP loan.
Q: If dividends aren’t deductible, why do companies still pay them?
A: Because investors expect them. Mature companies often have more profit than they can reinvest, so they return it to shareholders via dividends despite the tax cost. Dividends also attract investors and reward them.
Q: What’s the difference between dividends and share buybacks, tax-wise?
A: Dividends trigger immediate taxable income for shareholders. Buybacks generally aren’t taxable to shareholders unless they sell stock (taxed as capital gains). The company faces a 1% excise tax on buybacks.