Not all dividends qualify for tax rate break
August 1, 2003
© 2003 by Michael C. Gray
The new rules for the taxation of dividends enacted as part of the Jobs and Growth Tax Relief Reconciliation Act of 2003 are very complex.
Many taxpayers will simply think, "dividends are now taxable as long-term capital gains", and they will be wrong. This new complexity will make it much harder for the average investor to make tax-wise investment decisions.
It may help to remember the purpose of the new tax rate is to reduce the double-taxation of corporate dividends. When interest is paid by a business, it's usually tax deductible. Dividend payments are not tax deductible.
Many payments are called dividends, when they are actually a form of interest. For example, "dividends" from a credit union savings account are interest. "Dividends" from a mutual fund that invests in bonds or from a money market account that invests in Treasury Bills are payments of shares of interest income to fund investors. These payments are not "qualified dividends" for the low tax rates.
Also remember: dividends that qualify for the low tax rate are not being taxed as long-term capital gains. They are simply a class of income qualifying for special tax rates. The tax rates happen to be the same as those applying to long-term capital gains. Qualifying dividends are not combined with other capital gains to determine the amount of capital loss that is deductible for a taxable year.
Here is some information about which dividends qualify for the special rates, and which do not.
The general rule is reduced rates apply to dividends received during a tax year from 1) a domestic corporation or 2) a qualified foreign corporation. A qualified foreign corporation has stock that is traded on a U.S. stock exchange. The qualifying dividends will be identified on Form 1099-DIV.
Here are some dividends ineligible for the reduced tax rates:
- credit unions
- mutual insurance companies
- farmers' cooperatives
- tax-exempt cemetery companies
- nonprofit voluntary employee benefit associations (VEBAs)
- dividends paid for securities owned by an employee stock ownership plan (ESOP) that qualify for a tax deduction by the employer
- tax-exempt corporations under Internal Revenue Code Sections 501 or 521 in the tax year or preceding tax year of the dividend payment
- mutual savings banks, savings and loans, domestic building and loan, cooperative bank or other bank eligible for a dividends-paid deduction.
- stock owned for less than 60 days in the 120-day period surrounding the ex-dividend date
- stock purchased with borrowed funds if the dividend was included in investment income in claiming an interest deduction
- stock with respect to which related payments must be made with respect to substantially similar or related property
- substitute payments in lieu of a dividend made with respect to stock on loan in a short sale.
Note the holding period rule. The stock must be held for at least 60 days in the 120-day period beginning 60 days before the ex-dividend date for the reduced rates to apply.
Brokerage companies will have major headaches getting correct information to their investors to comply with these rules.
Since dividends that qualify for the low rates are not investment income in determining the deduction limitation for investment interest expense, investors who margin their investments will have special headaches to deal with. A taxpayer may elect to have otherwise qualifying dividends taxed as ordinary income to enable more investment interest expense to be deducted.
Mutual funds and REITs pass through their income by payments to their investors. The income will retain its character as qualifying or non-qualifying dividends.
These new rules may result in taxpayers trying strategies that are the opposite of traditional tax planning strategies. For example, an owner-employee of a closely-held corporation may decide to classify amounts paid from the corporation to him or her as dividends (taxed at 15% with no tax deduction to the corporation) instead of wages (taxed at up to 35% with a tax deduction to the corporation.) We may see some new, interesting "reasonable compensation" disputes with the IRS.
Corporate penalty taxes based on the dividend rates have been dramatically reduced. The personal holding company tax and the tax on excess accumulated earnings have been reduced to 15%.
Many corporations that have been hoarding cash (such as Microsoft) will be pressured by shareholders to pay the cash out as dividends.
Remember the reduced tax rates applying to qualified dividends are 15% for most individuals, or 5% for those whose incomes fall in the 10 or 15% rate brackets. The rates apply for dividends received from January 1, 2003 through December 31, 2008. A zero percent rate applies to taxpayers in the 10 or 15% rate brackets for 2008 only.
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