Generally dividends you receive on stock you own are taxable. Most dividends are taxed similar to capital gains at a rate of 15% (20% if clients are in the 39.6% tax rate bracket).
Dividends that qualify for this reduced tax rate include most dividends received from domestic corporations and some foreign corporations. This includes dividends received from mutual funds if the distribution is otherwise a qualified dividend.
[This article is course content for the Tax Season 2016 CPE quiz, worth 3 CPE credits! Reach the quiz and additional content HERE.]
Dividends that do not qualify for this reduced tax rate include dividends from stocks owned for fewer than 60 days in the 120-day period surrounding the ex-dividend date, dividends that you include in investment income for purposes of claiming the investment interest deduction, and certain other dividends in special circumstances.
The benefit of this reduced tax rate on dividends only applies to dividends received. Any amounts received in individual retirement accounts or retirement plans are taxed at ordinary income tax rates when they are withdrawn. Recommend a review of investment allocation between taxable accounts and retirement plan accounts.
The Following Dividends are Taxable:
• Some dividends are really interest income. Some income on deposits that are called dividends should be reported on Schedule B as interest income. Examples include dividends from:
• Cooperative banks
• Credit unions
• Savings and loans
• Mutual savings banks
On the other hand, the income from money market fund accounts, which is often called interest income, should be reported as dividend income although such amounts will not qualify for the lower tax rate on qualifying dividends. The proper reporting of interest and dividend income is important because misreporting this income can trigger a notice from the IRS when the IRS cannot match what is reported with the information they have received. Responding to these notices is time consuming.
• Capital gain distributions. These are distributions you get from your mutual funds. They are taxable as long-term capital gains. Many mutual funds make these payments in December. Capital gain distributions are taxable even if reinvested and do not actually generate cash.
• Reinvested dividends. Many publicly held corporations maintain dividend reinvestment plans which permit additional share purchases through reinvestment of dividends and, in some cases, through optional cash payments. The amount of dividends reinvested is treated as a dividend received and is taxable. The dividends are taxable even though the client does not physically receive cash or the stock.
Some Dividends are Not Taxable. The Most Common Taxable Dividends are:
• Stock dividends and stock splits. These are additional shares of stock received from a corporation. They are not taxable if they do not increase the percentage of ownership in the corporation. If the client receives a stock dividend or stock split, the client must allocate the basis of the old shares between the client’s old shares and the new shares. The holding period for the stock received from a stock dividend or a stock split goes back to the time when the client bought the original shares. The holding period is important because it determines if the client qualifies for the 15% (0% if in the 10% or 15% tax rate bracket) long-term capital gain tax rate. If the stock dividend or stock split is taxable, then the basis in the new shares is the fair market value of the stock when it is received. The holding period for the new stock would then start on the date of receiving the new stock.
A client owns 100 shares of XYZ Company bought two years ago for $1,000 ($10 per share). XYZ Company declares a 2-for-1 stock split and the client receives 100 additional shares of XYZ Company stock. This stock split is not taxable because all of the shareholders of XYZ own the same percentage of the corporation as they did before the stock split. They just own twice as many shares. The new basis in the stock is $5 ($10/2) per share, for a total basis in the 200 shares of $1,000. Since the client owned the old stock for two years, the client is treated as if he or she owned the new stock for two years. Thus, if the client sells the stock at a gain, it will be a long-term capital gain.
• Insurance policy dividends. These are rebates from premiums paid on life insurance policies. They are not taxable unless the total rebates received are more than the premiums paid for the policy.
• Return of investment and liquidating dividends. Return of investment dividends are amounts received on stock owned when the company has no accumulated earnings. They are not taxable since taxable dividends must be paid from a corporation’s earnings. Public utility stocks, besides paying dividends at a high rate of return, often distribute return of investment dividends that are not currently taxable. Liquidating dividends are distributions received in a partial or complete liquidation of the company. Both return of investment dividends and liquidating dividends are treated as a nontaxable recovery of capital and reduce the basis in the stock. Once the basis is reduced to zero, any future distributions are taxed as capital gains.
• Patronage dividends. These are dividends received from cooperatives. The most common recipients are farmers and students. The dividends are treated as purchase rebates and reduce the cost of items purchased from the cooperative, such as feed or books. They may be taxable if the client previously deducted the cost of the items.
Julie Welch (Runtz) is the owner of Meara Welch Browne. She graduated from William Jewell College with a BS in Accounting and obtained a Masters in Taxation from the University of Missouri- Kansas City. She serves as a discussion leader for the AICPA National Tax Education Program. She is co-author of 101 Tax Saving Ideas.