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Taxation of Ordinary and Qualified Dividends

Ordinary dividends are distributions of money, stock, or other property to holders of an ownership interest in the distributor. The most common issuers of dividends are corporations and mutual funds, but the issuer can also be a partnership, estate, or trust.

Dividends are reported to the IRS and to the receivers of the dividends on Form 1099-DIV, Dividends and Distributions. Some distributions that are called dividends are actually considered interest, such as the distributions received from building and loan associations, cooperative banks, savings and loan associations, credit unions, and mutual savings banks. These distributions are reported on Form 1099-INT, Interest Income .

Other distributions that are often referred to as dividends are actually the return of invested capital, such as the premiums on a life insurance policy.

Ordinary and Qualified Dividends

Ordinary dividends are considered ordinary income, not capital gains, and are taxed as such. However, qualified dividends are taxed at the same marginal rate as net long-term capital gains. 0%, 15%, and 20%. The 0% rate applies to lower income taxpayers where the top marginal tax rate on ordinary income is less than 25%; otherwise the 15% rate applies. Starting in 2013, qualified dividends will be subject to a marginal tax rate of 20% for those in the 39.6% bracket plus the 3.8% Medicare surtax. The 3.8% Medicare surtax will also apply to the 15% qualified dividend rate for those who earn more than the income threshold for that tax (single and head of household: $200,000; married filing jointly: $250,000) .

Another advantage: qualified dividends, like tax-exempt interest, but unlike ordinary dividends, do not contribute to adjusted gross income (AGI) on Form 1040, so they do not increase the likelihood that some tax benefits may be restricted or eliminated because of income limitations.

Qualified dividends must satisfy the following requirements:

  • They were distributed by a US corporation or a qualified foreign corporation.
    • A qualified foreign corporation is one that is incorporated in a United States possession, incorporated in a country that has a comprehensive income tax treaty with the United States, or its securities are readily tradable on a United States public stock exchange.
  • Holding Period. The stock was held for more than 60 days during a 121 day period that begins 60 days before the ex-dividend date. However, if the security is preferred stock, then the applicable holding period is more than 90 days during the 181 day period that begins 90 days before the ex-dividend date if the dividends were for a period of greater than 366 days; if the period is less than 367 days, then the 121 day rule applies. The holding period is shortened by the number of days the holder hedged his position, reducing his risk for loss, such as selling a put on the stock or selling the stock short.

If the dividend is a qualified dividend, then it will be reported as such on Form 1099-DIV .

If the dividend comes from a mutual fund or exchange traded fund. then both the fund and the shareholder must both satisfy the holding period requirement. However, some funds may list the dividend as qualified if they satisfy the holding period requirement, even if the shareholder does not satisfy the requirement. In this case, the shareholder has to treat the income as ordinary income.

There are some dividends that are disqualified by IRS rules, including:

  • dividends that are actually capital gain distributions or interest,
  • distributions from tax-exempt organizations or a farmer's cooperative,
  • payments in lieu of dividends, which are the payments received by holders of the stock from people who have shorted the stock.
    • However, this last rule only applies if the stockholder knows or has reason to believe that the payment is a payment in lieu of dividends .

Some companies and most mutual funds have dividend reinvestment plans that generally allow the shareholder to reinvest the dividend by buying more shares of the company or fund. Although the dividends are reinvested, they must still be reported as income. If the reinvestment plan also allows the shareholder to buy more stock at less than fair market value, then the difference between the fair market value of the stock and the purchase price must also be reported as income.

Other Distributions

Capital gain distributions received from a mutual fund or other regulated investment company, or a real estate investment trust (REIT) should be reported as long-term capital gains regardless of how long the shareholder held the shares. Sometimes these distributions are not paid to the shareholder, but are retained by the company to reinvest. However, these capital gains still have to be reported by the shareholder even though they were not received. The shareholder will be notified by a Form 2439, Notice to Shareholder of Undistributed Long-Term Capital Gains .

A non-dividend distribution is a return of invested capital, which is reported on Form 1099-DIV. A non-dividend distribution reduces the tax basis of the stock; thus, taxes are not paid until the stock is sold. The tax basis

of the earliest purchased stock is reduced first, until the basis of all stock reaches zero. Any additional nondividend distributions must be reported as a capital gain. So if you buy mutual fund shares for $100, and receiving nondividend distributions of $70, then sell the shares for $110, your profit will be $40.

Liquidating distributions. which are sometimes called liquidating dividends. or a return of capital that results from the partial or complete liquidation of the corporation. Liquidating distributions reduce the tax basis of the stock. If the distribution results in the redemption or cancellation of the stock, then the taxpayer may have a capital loss.

Stock dividends and stock rights are generally not taxable, since they are just increasing the number of outstanding shares of stock, which decreases the value of each individual stock accordingly. However, stock dividends and rights may be taxable if the holder has the right to receive cash or other property instead of the stock or stock rights, or if the distribution results in an increase in the ownership interest of each shareholder. Constructive distributions. such as preferred stock that is redeemable at a premium to the issue price, are also taxable.

Dividends from stripped preferred stock are treated as ordinary income.

Because many stockholders will not own enough shares to receive a full share of stock in a dividend or rights distribution, the company will sometimes sell the shares and divide the proceeds among the stockholders, which results in a taxable distribution equal to the amount of cash received by the stockholder minus the basis of the fractional share sold.

Some corporations issue so-called script dividends. which is based on a script certificate that entitles the stockholder to a fractional share of the corporation. Script dividends are generally not taxable unless the corporation sells it and gives the stockholder the proceeds. The income will be equal to the income received minus the basis allocated to the certificate. If the certificate is redeemable for cash, then its fair market value is taxable income as of the date it is received.

Some dividends are not taxable income including:

  • exempt-interest dividends received from a mutual fund or other regulated investment company. However, exempt interest dividends must be reported.
  • Dividends paid by insurance policies which are a return of premiums.
  • Dividends from veterans' insurance are also not taxable.

Reporting Dividend Income

Dividends of $1,500 or less are reported on Form 1040 or 1040A . Dividends greater than $1,500 or a nominee receiving any amount of dividends that actually belong to someone else must file Schedule B, Interest and Ordinary Dividends and attach it to Form 1040. Dividends are reported on Form 1099-DIV . although some dividends that are actually interest will be reported on Form 1099-INT .

If the taxpayer received dividends from restricted stock for services performed either as an employee or independent contractor. then these dividends must be reported as wages rather than as dividend income.


Qualified Dividend-Paying Stock Funds

Dividend-paying stocks generally don't yield as much as bond funds, but they do have a greater potential for capital appreciation, and with qualified dividends, the top tax rate for the dividend income is 15% for most investors, and only 5% for people in the 2 lowest tax brackets. As an example, Goldman Sachs Growth and Income Fund is currently yielding about 1.5%, but its gains, with stock appreciation, through October 31, 2006 is 17.84%.

Because funds of other countries pay higher dividends than in the United States (S&P 500 average: less than 2%), many stock funds buy qualified foreign stocks paying 5% to 7%. Alpine Dynamic Dividend Fund. for instance, had a yield of 12.6% through October 31, and a total return of 14%.

The preferential tax treatment, which will expire in 2010 unless renewed by Congress, applies only to dividends paid by many United States and foreign companies, not to cash distributions earned through other investments of the mutual fund, such as earned interest, even if the fund holds mostly qualified dividend-paying stocks. The mutual fund will designate which earnings are qualified dividends on the Form 1099-DIV .

Qualified Dividend Holding Periods for Mutual Funds

Mutual funds, other regulated investment companies, and real estate investment trusts that pass through dividend income to their shareholders must meet the holding period test for the dividend-paying stocks that they hold in order for corresponding amounts that they pay out to be reported as qualified dividends on Form 1099-DIV. Investors must then meet the test relative to the shares that they hold directly, from which they received the qualified dividends that were reported to them.

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