Tax Effects of Dividends From Wholly Owned Subsidiary

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Will 17 years ago

I was reading through one of Warren Buffet's annual reports for Berkshire Hathaway, and it contain the following as an explanation for why he prefers to buy companies instead of just invest in them as marketable securities:

"...there's also a powerful financial reason behind the preference, and that has to do with taxes. The tax code makes Berkshire's owning 80% or more of a business far more profitable for us, proportionately, than our owning a smaller share. When a company we own all of earns $1 million after tax, the entire amount inures to our benefit. If the $1 million is upstreamed to Berkshire, we owe no tax on the dividend. And, if the earnings are retained and we were to sell the subsidiary-not likely at Berkshire!-for $1 million more than we paid for it, we would owe no capital gains tax. That's because our "tax cost" upon sale would include both what we paid for the business and all earnings it subsequently retained."

There are two components to this paragraph that I want to flesh out and better understand:

1) If a C corporation wholly owns another C corporation, the parent is not taxed on dividends paid by the child. Is that right? Obviously the child corporation paid taxes on net income and the dividend is on after-tax income.

I assume that this tax advantage would not exist if the parent was an S Corporation? In that case, the dividend of the child C corporation would flow through the S Corporation to the shareholders of the S corporation, and it would be taxed just as if those shareholders had received the dividend directly from the C corporation? Is the tax benefit he is describing here only applicable if the parent is a C corporation?

2) His second statement seems to be that the dividends received by the parent will increase the parent corporation's cost basis in the child corporation by the amount of the annual dividend. That statement I find remarkable. Since the government is not taxing the dividend, why would the government double the tax benefit by also giving the parent corporation some additional cost basis in the child corporation, which the parent could use to shield the same amounts as the dividend from any capital gains on a future sale?

Are there other similar cases to 2) in the US tax codes, where some kind of dividend or ordinary income will increase cost basis in an asset?

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Tyler Franks 17 years ago

The "dividend" was taxed. As income to the Child Corp. It was not DOUBLE taxed. The advantage of 80% is not that much different than if it were 100% (or two divisions of one company). If one division makes a profit (and is taxed) but the proceeds are then moved to another division, there should of course be no tax on the movement. Drawing the line at 80% is just a number, but imagine how a 98% or 95% owned company might be justifiably upset at double taxation if we set the number at specifically 100%.

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Bill Brown 17 years ago

Dividends paid by a 100% owned subsidiary to it's parent are accompanied by a 100% dividends received deduction if other critieria are met.

The only basis effect I'm aware of of dividends paid by a sub to a parent is in financial accounting, not income tax accounting. According to GAAP (generally accepted accounting principles) dividends received from a 20% or greater owned subsidiary (that is not consolidated with the parent) REDUCE the parent's GAAP basis in the subsidiary.

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Seth 17 years ago

. . .

It's the other way around: when the subsidiary company earns, say, $1.5 million and pays $.5 million in income tax (net $1 million), and holds onto that $1 million, the basis goes up by $1 million. (Otherwise, consider it paying that $1 million to its parent as a dividend, which is tax free, and the parent turning around and investing the $1 million in the subsidiary by buying new stock. That would increase the basis by $1 million, so why require the excess manipulation?)

Seth

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Dick Adams 17 years ago

If and only if the subsidiary is allowed to file a separate tax return. Otherwise it's an intercompany transaction.

My recollection is that the issue is a shareholder of influence and 20% is the minimum set for influence, but it is rebutable. Also doesn't this apply to accrual-basis entities and doesn't retained earning come into play.

But an S-Corp is a cash-basis entity. So is there really any benefit there?

Dick

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Seth 17 years ago

Don't you mean "intracompany"?

Seth

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Katie 17 years ago

Everything in the Buffett paragraph derives from the fact that a parent corporation that owns 80% or more of the stock of a subsidiary may elect to file a consolidated federal income tax return, which brings to bear the regulations under IRC Sec. 1102.

Under the consolidated return rules, intercompany dividends between members of the consolidated group are eliminated to the extent they are paid from earnings and profits that were included in the consolidated net income base. So, no tax on the subsidiary's payment of a dividend to Berkshire from its income earned in a consolidated return year. Also, the consolidated return rules provide that the parent's basis in the stock of a consolidated subsidiary is adjusted upwards for net income included in the consolidated return, and downwards for net losses. It is also adjusted downwards for dividends paid by the sub to the parent. As a result, if the subsidiary retains its earnings rather than paying a dividend to Berkshire, Berkshire's basis in the sub's stock is increased by the $1 million, which reduces the gain realized by Berkshire on its subsequent sale of the sub's stock. (Read the sentence in the Berkshire paragraph more carefully: "...if the earnings are retained [by the sub -- i.e., not distributed to Berkshire as a dividend] and we were to sell the subsidiary-not likely at Berkshire!-for $1 million more than we paid for it, we would owe no capital gains tax.")

These rules do not apply if each of the corporations files a separate federal income tax return. Generally consolidated filing is more beneficial in the long run than separate filing, and parent corporations that own, directly or indirectly, 80% or more of the stock of one or more subsidiaries often elect to file consolidated. If they file separately, the parent is entitled to a dividends received deduction (DRD) pursuant to IRC Sec. 243, which exists to mitigate the multiple taxation of corporate income when it flows up through chains of corporate stockholders. If the parent owns at least

80% of the subsidiary's stock, the DRD is 100% of the dividend received, provided other statutory requirements (holding period, etc.) are met. A corporation that owns less than 20% of the stock of another corporation gets a 70% DRD; if it owns more than 20% but less than 80%, the DRD is 80% of the dividend received.

An S corporation cannot be included in a consolidated federal income tax return. S corporations compute their taxable income llike an individual; therefore, they are not entitled to the dividends-received deduction. As you suggest, the elimination or DRD reduction of dividends received is not applicable if the stockholder is an S corporation.

Katie in San Diego

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Tax Effects of Dividends From Wholly Owned Subsidiary

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