Dividends
are taxed at the same favorable 5% and 15% rates that apply to long-term
capital gain (for purposes of both the regular tax and the alternative minimum
tax)—but only if the dividends are “qualified dividend income.” (Dividends that
aren't qualified dividend income are taxed at the same up-to-35% rates that
apply to ordinary income.)
Generally,
qualified dividend income means dividends received during the tax year from:
domestic corporations, or
qualified foreign corporations (that is,
with certain exceptions, U.S. possessions corporations, foreign corporations
whose stock is traded on established U.S. securities markets, and foreign
corporations eligible for income tax treaty benefits).
However,
in order for you to treat a dividend as qualified dividend income, you must
hold the underlying stock for at least 61 days during the 121-day period
beginning 60 days before the ex-dividend date. If the dividend was declared on
preferred stock and is attributable to a period of more than 366 days, you must
hold the underlying stock for at least 91 days during the 181-day period
beginning 90 days before the ex-dividend date.
Qualified
dividend income does not include the following:
(1) any dividend
on any share of stock to the extent the taxpayer is under an obligation to make
related payments with respect to positions in substantially similar or related
property, for example, in connection with a short sale;
(2) any payment in lieu of dividends, for
example, payments received by a person who lends stock in connection with a
short sale;
(3) any dividend
that you elect to treat as investment income for purposes of the rules
governing the deduction of investment interest;
(4) any dividend
from a tax-exempt charitable, religious, scientific, etc., organization,
religious or apostolic organization, qualified employee trust, or farmers'
cooperative;
(5) any
deductible dividend paid by mutual savings banks, etc.;
(6) any
deductible “applicable dividends” paid on “applicable employer securities” held
by an employee stock ownership plan (ESOP).
Mutual fund dividends. The qualified dividend income rules
discussed above apply to dividends on stock that you own, directly or through a
brokerage account. What about dividends from mutual funds? If you own shares of
a mutual fund that holds dividend-paying stock, and if you meet the holding
period requirements discussed above with respect to those mutual fund shares,
then, to the extent that the dividends received by the mutual fund are
qualified dividend income, you are entitled to treat the dividends you receive from
the mutual fund as qualified dividend income, taxable at the 5% or 15% maximum
rates. The mutual fund should notify you, by means of Form 1099-DIV, how much
of your income from the mutual fund is eligible for qualified dividend income
treatment.
Dividends
received by other pass-thru entities. In addition to mutual funds, you may have interests in
other types of “pass-thru” entities that receive qualified dividend income
that's “passed through” to you—e.g., partnerships, S corporations, estates,
trusts, real estate investment trusts (REITs). By and
large, you may treat your share of the qualified dividend income of these
entities as qualified dividend income. As in the case of mutual funds, these
entities should notify you, on the appropriate form, how much of your share of
their income is eligible for qualified dividend income treatment.
Effect of capital losses on dividends. While qualified dividend income is taxed
at the same rates as long-term capital gain, it isn't actually long-term
capital gain. Therefore, you can't use capital losses that otherwise enter into
the computation of your taxable “net capital gain” (the excess of net long-term
capital gain over net short-term capital loss) to offset your qualified
dividend income. As a result, generally, your qualified dividend income will be
taxed in full at the 5% or 15% rates.
However,
if your capital losses exceed your capital gains for the tax year, the excess,
up to $3,000, can be used to offset other income. This offset can be used
against qualified dividend income, but only after it's been used against
taxable income other than qualified dividend income. However, this “ordering”
rule is actually a benefit, because offsetting taxable income other than
qualified dividend income, which is taxable at rates up to 35%, saves more tax
than offsetting qualified dividend income, which is taxed at no more than 15%.
Planning. The taxation of dividends at the highly favorable 5% and
15% rates otherwise applicable only to long-term capital gains may make
investment in dividend-paying stock significantly more advantageous than other
types of investments that produce income taxed at the regular up-to-35% rates
(for example, rental real estate, or any type of investment that produces
taxable interest). If you have any questions or if you would like to discuss
some planning strategies with us, please call.