Good News/Bad News: For Dividends, New Tax Law Means Lower Rates But More Headaches

    by Ellen J. Boling

    The good news: The tax rates went down.

    The bad news: Simplification went out the window.

    It is hard to imagine that taxes could get more complicated. But for dividends, at least, they just did. Prior to the passage of The Jobs and Growth Tax Relief Reconciliation Act of 2003, income taxation of dividend income was a relatively simple concept. All dividend income was treated as ordinary income and subject to tax at the taxpayer’s marginal tax rate. In 2002, the highest marginal tax rate for an individual taxpayer was 38.6%.

    However, on May 28, 2003, President Bush signed the Tax Relief Act, which significantly changed the landscape for the income taxation of dividend income. Effective for taxable years beginning after December 31, 2002, and before January 1, 2009, the top tax rate for “qualified dividend income” received by an individual taxpayer is 15%.

    What does it mean to be “qualified?”

    This article highlights the requirements for qualified dividend income classification. Additionally, we’ll focus on specific areas of the tax law relative to qualified dividend income that have caught some taxpayers by surprise. In particular, we’ll cover the impact of margin accounts; the limitations on investment interest deduction; and the use of common equity hedging techniques.

    Qualified Dividend Income

    For income tax purposes, the Internal Revenue Code defines a dividend as any distribution of property made by a corporation to its shareholders out of its earnings and profits accumulated after February 28, 1913, or out of its earnings and profits generated in the current taxable year.

    For tax years beginning after December 31, 2002, dividend income received by individual shareholders of domestic or qualified foreign corporations will be taxed at a maximum rate of 15%. If an individual taxpayer is in the 10% or 15% tax brackets, their qualified dividend income will be taxed at a maximum rate of 5%.

    The 15% rate for qualified dividend income will remain in effect through 2008 for taxpayers in the 25% or higher tax bracket. The 5% rate remains in effect through 2007 for lower-bracket taxpayers, and drops to zero for 2008. Table 1 highlights the maximum tax rates for dividends under the current tax law.

    TABLE 1. Changing Rates: An Overview of Dividend Taxes Through 2009
    Dividend Tax Rate
      2003 2004 2005 2006 2007 2008 2009
    25% or Higher Tax Bracket 15% Ordinary
    10% & 15% Tax Bracket 5% 0% Ordinary

    “Unqualified” Dividends

    Some dividends will not be eligible for taxation as qualified dividend income. Generally, the ineligible include the following:

    • Dividends received on stock that has not met the revised holding period requirements as described below;

    • Dividends related to short sales, where the taxpayer is obligated to make related payments for positions in substantially similar or related property;

    • Dividends received from certain tax-exempt organizations;

    • Dividends received from mutual savings banks, cooperative banks, domestic building and loan associations and other savings institutions for which the bank or savings institution took a tax deduction; and

    • Deductible dividends paid on employer securities held in an employee stock ownership plan.

    Pass-Through Dividends

    Stock dividends passed through to taxpayers by a mutual fund or other regulated investment company, partnership, real estate investment trust (REIT), or held by a common trust fund are eligible for the reduced tax rate, assuming the distribution would otherwise be classified as qualified dividend income.

    Dividends received from regulated investment companies and REITs may qualify as qualified dividend income:

    • If at least 95% of the regulated investment company’s and REIT’s gross income is derived from dividends of domestic C corporations and/or qualified foreign corporations.

    • In situations where such dividends account for less than 95% of gross income, dividends paid by regulated investment companies and REITs generally will qualify as qualified dividend income only to the extent that the regulated investment companies and REITs have received dividends from qualifying corporations. Typically, dividends paid by REITs are comprised of rents and other earnings and not dividends from other corporations. Therefore, the majority of the dividends paid by REITs will generally be taxed as ordinary income and only a small portion may qualify as qualified dividend income.

    Required Holding Period and Margin Accounts

    One of the requirements for dividends to qualify for the 15% maximum tax rate is that the individual taxpayer must have held the dividend-paying stock for more than 60 of the 120 days surrounding the “ex-dividend” date of the stock.

    The 120-day period begins 60 days prior to the ex-dividend date and ends 60 days after the ex-dividend date. This holding period requirement must be met in reference to each ex-dividend date related to each dividend payment. If the taxpayer fails to meet the holding period requirement, the dividend will not be eligible for the 15% tax rate and, consequently, the dividend will be taxed at ordinary income tax rates.

    An interesting twist to the holding period requirement occurs when a taxpayer receives dividends on stock held in a margin account. Taxpayers may be surprised upon receipt of their tax reporting statements at the end of the year that not all of their dividends qualify for the 15% tax rate.

    Generally, when a taxpayer enters into a margin agreement with a broker, the agreement contains a clause that allows the broker to borrow shares from the taxpayer’s account and return them at a later date, without pre-approval from the taxpayer. Typically, the broker will borrow shares from a large pool of shares it holds in street name on behalf of all its customers and lend the shares to another party to use in a short sale. The broker will later allocate the borrowed shares to particular customers. Although the taxpayer may not be aware that the broker has borrowed shares, the loan of the shares will affect the taxpayer’s holding period of the dividend-paying stock. This could potentially make the dividends ineligible as qualified dividend income.

    This occurs because the taxpayer no longer owns the shares if the broker borrows them. Therefore, the taxpayer will not receive a dividend. Instead, the taxpayer receives “payments in lieu of dividends,” which are not dividends and are not eligible for qualified dividend income treatment. Payments in lieu of dividends are taxed at ordinary income tax rates.

    This issue did not present a problem for taxpayers in tax years beginning before January 1, 2003, because dividend income was classified as ordinary income and therefore taxed at the same rate as payments in lieu of dividends.

    Reporting of Payments
    The proper distinction between dividends and payments in lieu of dividends was not critical prior to the passage of the recent tax act. However, the 15% maximum tax on qualified dividend income has made proper reporting critical to ensure that payments are correctly identified and taxed accordingly. Prior to 2003, dividends and payments in lieu of dividends were typically both reported on Form 1099-DIV. The Internal Revenue Service addressed this issue in September of 2003, requiring brokers to report payments in lieu of dividends on Form 1099-MISC, as opposed to Form 1099-DIV.

    The IRS realized that compliance with the new information reporting requirements would take time. Consequently, penalties will not be assessed against brokers for misclassification of payments in lieu of dividends for calendar year 2003 if the broker made a good faith effort to satisfy its information reporting obligations. If a payment in lieu of dividends is reported as dividend income on a 2003 Form 1099-DIV, the taxpayer may treat the payment for tax purposes as a dividend, unless the taxpayer knows or has reason to know the actual character of the payment. The IRS expects full compliance with the information reporting requirements for all calendar years after 2003.

    What Can You Do?
    For tax planning purposes, taxpayers may consider moving their high dividend-paying stocks from margin accounts to cash accounts, in order to increase the likelihood that the dividends qualify for the 15% tax rate. Alternatively, the taxpayer may inquire as to whether the broker has historically borrowed shares from the taxpayer’s account. If so, the taxpayer should require the broker to sign an agreement against borrowing stock from the taxpayer’s account. Some brokerage firms have policies that state that they generally do not borrow shares from non-institutional investors.

    At a minimum, if the taxpayer has dividend-paying stock in a margin account, they should address this issue with their broker as soon as possible. Although this issue did not tend to cause the average taxpayer much anguish in 2003, it unfortunately could have a serious impact in 2004 and beyond.

    Investment Interest Expense Limitation

    In order for interest expense to qualify as investment interest expense, it must represent interest paid or accrued on debt that is allocable to property held for investment purposes. Generally, investment interest is deductible by a taxpayer in a given year to the extent that the taxpayer has “net investment income” in that tax year. In the event that the taxpayer’s investment interest exceeds net investment income in a given year, the excess investment interest is carried forward to future tax years. The carryforward is indefinite and can be utilized in years when the taxpayer has net investment income available.

    Net investment income is defined by the Internal Revenue Code as interest income, dividend income and capital gain income derived from property held for investment in excess of investment expenses.

    Prior to the passage of the recent Tax Relief Act, dividend income qualified as net investment income for purposes of determining the taxpayer’s deductible investment interest. Starting in 2003, qualified dividend income that is subject to the 15% maximum tax rate will not be included in the taxpayer’s net investment income. However, the taxpayer may elect to treat qualified dividend income as net investment income to allow the current deduction of the investment interest. If the election is made, the portion of the taxpayer’s qualified dividend income that is classified as net investment income will be taxed at the taxpayer’s marginal tax rate, rather than the preferential 15% rate. Since taxpayers may elect to classify any or all of their qualified dividend income as net investment income in a given year, they are forced to make a difficult decision:

    • Would they be better off having all of their qualified dividend income taxed at 15% and carry forward their investment interest expense to future years? Or,

    • Should they elect to treat their qualified dividend income as net investment income and take a current deduction for their investment interest, yet have their dividend income taxed at their marginal rate?
    The answer depends upon various facts and circumstances. The election to classify qualified dividend income as net investment income will typically cause the taxpayer to have an overall lower tax cost in the current year, but it may not provide the lowest tax cost over a period of years.

    To begin the analysis, it will be necessary for the taxpayer to project their future marginal tax rates and the amount of interest income, non-qualifying dividend income and short-term capital gains that would be subject to tax at these calculated marginal rates. The amount of investment interest that may be generated in future years must also be taken into consideration.

    If it appears that the taxpayer will have sufficient net investment income in the future (exclusive of dividends) to fully deduct the investment interest expense, the taxpayer will likely decide against classifying any of their qualified dividend income as net investment income. Generally, it is in the taxpayer’s best interest to prepare projections to assist in making informed decisions. The best strategy will be predicated upon each individual taxpayer’s specific set of facts and assumptions.

    Common Equity Hedging

    For taxpayers with concentrated stock positions, it is not uncommon for the taxpayer to enter various hedging transactions to assist in reducing their exposure to market risk on that stock. Three frequently used hedging transactions are: purchasing a put option; entering into an equity collar; or entering into a variable prepaid forward contract. Unfortunately, by entering into one of these hedging transactions, the taxpayer will impact the taxation of the dividends of the underlying stock. The Internal Revenue Code states that a taxpayer’s holding period for stock will be reduced during any period in which the taxpayer:

    • Has entered into an option to sell; is under a contractual obligation to sell; or has made a short-sale of the same or substantially identical stock or securities;

    • Is the grantor of an option to buy the same or substantially identical stock or securities; or

    • Under regulations prescribed by the IRS and the Treasury, has diminished risk of loss by holding one or more other positions with respect to substantially similar or related property.
    The purchase of a put option on stock or a substantially identical security, as well as entering into an equity collar on stock or a variable prepaid forward contract causes any dividends paid during the period of the option contract, equity collar or forward contract to lose preferential qualified dividend income classification. Consequently, such dividends will not be eligible for taxation at the maximum rate of 15%.


    The preferential tax rate afforded to qualified dividend income will impact most taxpayers that receive dividend income. But there are several nuances of the qualified dividend income rules that may catch some taxpayers by surprise.

    Taxpayers are strongly encouraged to consult with a professional tax advisor or financial planning advisor to understand how their dividends will be classified for income tax purposes and to discuss strategies for managing tax exposure.

       The Taxing Difference: Actual Dividends vs. Payments in Lieu of Dividends
    • George owns 500,000 shares of ABC Co. stock, held in a margin account at XYZ Brokerage
    • In 2003, ABC Co. paid a dividend of $1.50 per share
    • George receives $750,000 in payments based on the dividends paid on his ABC Co. stock
    • During the year, XYZ Brokerage loans George’s ABC Co. stock to facilitate short-sales transactions, which George consented to under the margin account agreement
    • Payments received by George related to his ABC Co. stock are classified as “payments in lieu of dividends”
    • Payments in lieu of dividends are taxed at George’s ordinary income tax rate of 35%, for a total tax bill of $262,500 ($750,000 × 35%)
    • Lois owns 500,000 shares of ABC Co. stock, held in a regular (non-margined) account at XYZ Brokerage
    • In 2003, ABC Co. paid a dividend of $1.50 per share
    • Lois receives $750,000 in payments based on the dividends paid on her ABC Co. stock
    • ABC Co. stock dividend payments are qualified dividend income
    • Since Lois is in the 25% income tax bracket, her qualified dividend income is taxed at 15%, for a total tax bill of $112,500 ($750,000 × 15%)
    The Difference in Tax Bills:

    $262,500 = $750,000 X 35% = George's bill (dividends treated as payment in lieu of dividends)
    $112,500 = $750,000 X 15% = Lois's bill (dividends treated as qualified dividend income)

    Ellen J. Boling, CFP, is director of Private Client Advisors for Deloitte & Touche, LLP, in Cincinnati, Ohio. Mark H. Gaudet, CPA, CFP, is a senior manager of Private Client Advisors for Deloitte & Touche, LLP, in Cincinnati.

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