Tax Effects of Dividends From Wholly Owned Subsidiary

[Will]

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?

 

[Bill Brown]

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?

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.

 

[Seth]

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." .. . .
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?

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

 

[Dick Adams]

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

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

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.

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

 

[Seth]

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

Don't you mean "intracompany"?

Seth

 

[Katie]

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?

--

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