Dividend Tax Cut Traps By Bradley D. Childs, CPA, Ph.D.
and Marilyn Young, CPA, Ph.D.
A
prominent feature of the Jobs and Growth Tax Relief required to hold the dividend-paying stock for at least 61
Reconciliation Act of 2003 (JGTRRA) is the new 15 per- days during a 121-day period surrounding the ex-dividend
cent tax rate on qualified dividend income.1 The new date. In the example above, this correction would expand the
tax law defines qualified dividend income as dividends paid holding period to June 30 and would allow investors buying
by most domestic corporations and qualifying foreign corpo- stock on the day before the ex-dividend date to qualify for the
rations. However, qualified dividend income does not include preferential rate.
distributions from tax-exempt organizations or mutual sav-
ings banks. In addition, mutual funds, real estate investment Trap #2: Interpreting the Qualified Divi-
trusts (REITs), partnerships and S corporations are allowed to dends Reported on the Form 1099
pass through qualified dividends to their investors. On the IRS Notice 2003-79, clarifying the reporting requirements of
surface, the provision for qualified dividend income seems Form 1099-DIV after the passage of JGTRRA, required the
straightforward, but like most issues involving dividends, payer of dividends to report total dividend distributions in
complexities abound. This article examines the potential traps Box 1a, and the amount of the total that qualifies for the pref-
of the new law that might prevent an individual investor erential rate to be reported in Box 1b. As the tax cut for divi-
from receiving the preferential rate on dividends. dends did not become law until May 2003, the information
systems of many brokers were not able to accurately report
Trap #1: The Holding Period either the amount of the qualified dividend income or the
Under the original provisions of JGTRRA, the holding period holding periods needed to determine if a dividend was quali-
required an investor to own the dividend-paying stock for fied. To give the dividend-reporting entities time to adjust to
more than 60 days during the 120-day period surrounding the the requirements of the new law, the IRS offered to waive
ex-dividend date.2 The purpose of the holding period require- accuracy penalties provided the reporting entity made a good
ment was to minimize the possibility of a double benefit to faith effort to prepare Form 1099s for the 2003 tax year.3
short-term investors. That is, without a holding period However, even if the investor’s Form 1099 was prepared
requirement, an investor could purchase shares of stock short- correctly, the qualified dividends reported in Box 1b are not
ly before the ex-dividend date, then sell the stock immediate- necessarily eligible for the preferential rate. Mutual funds,
ly after receiving the dividend. As the payment of a dividend REITs and investment companies that pass through dividend
typically causes stock prices to fall, this scenario would pro- income to their shareholders measure qualified dividend
duce a preferential rate for the dividend income and an ordi- income in reference to the entity-level holding period for the
nary income benefit on all or part of the capital loss resulting dividend-paying stocks that they own. In order for the
from the stock sale. [Yang and Chang, 2004] investor to qualify for the 15 percent rate, the investor must
However, the original definition of the 120-day holding hold the shares in the entity for the required holding period.
period carried unintended consequences. Specifically, [New York State Bar Association, 2003]
investors purchasing stock the day before the ex-dividend
date would be entitled to receive the declared dividend but
could not meet the requirements for obtaining a preferential
rate because the holding period window started 60 days prior
to the ex-dividend date. For example, if the ex-dividend date
was May 1, then the holding period window started on
March 2 (60 days prior to the ex-dividend date) and ran
through June 29 (60 days following the ex-dividend date). An
investor could receive the dividend if the stock was bought
on April 30; however, the rules of counting days for the new
preferential rate included stock disposition days but did not
include stock acquisition days. Consequently, the investor’s
holding days for the April 30 stock purchase would run May
1 through June 29, or 60 days. Even if the shareholder contin-
ued to hold the stock beyond June 29, the shareholder’s hold-
ing days within the holding period was one day less than the
necessary 61 days required by the original provisions of the
dividend tax law, and the shareholder would not qualify for
the preferential rate.
On Feb. 19, 2004, the IRS issued IR News Release 2004-22 to
announce that it expanded the holding period by one day,
effective for the 2003 filing season. Thus, an investor is now
6 TENNESSEE CPA JOURNAL: November 2004
Further, a good portion of mutual fund the investor’s account breaks the hold- qualified dividend income as long as
“dividends” received by the investor are ing period [New York State Bar Associa- taxpayers do not know or have reason
not reported as qualified dividends on tion, 2003, p. 276]. Further, since the to know otherwise.4 As most retail cus-
Form 1099s because the underlying issuance of Revenue Ruling 60-177, the tomers of brokers have no knowledge
income is not dividends, but something IRS has consistently held that substitute that their stock might be the subject of a
else, such as interest income. Similar dividends are not dividends. As these loan, most investors can get the maxi-
rules apply to income distributed from substitute payments meet neither the mum 15 percent tax rate on their substi-
deposits at credit unions and distribu- holding period requirement nor the def- tute dividends for the 2003 tax year.
tions on preferred stock where the inition of a dividend, they are ineligible Investors can avoid substitute dividends
underlying security is in substance a for the preferential rate. in the future by moving their stock
debt instrument [Yang and Chang, Before JGTRRA, actual dividends and holdings from margin accounts to cash
2004]. substitute dividends were both taxed at accounts [New York State Bar Associa-
ordinary rates, and if these different tion, 2003, p. 277].
Trap #3: Cash In-Lieu of Divi- payments were not disclosed separately
dends Are Not Dividends on an investor’s Form 1099, it would not Trap #4: Qualified Dividends
The legislative history of JGTRRA sug- impact the shareholder’s tax liability. Require a Risk of Loss
gests that many taxpayers will receive However, the creation of the preferential If individual investors hedge their stock
information statements inaccurately rate for only the qualified dividends will ownership in such a way that the share-
reporting “cash in lieu of dividends” as require brokers to distinguish between holder’s risk of loss is diminished, then
qualified dividend income. The origin actual and substitute dividends on the those days of hedging are not counted
of these dividends is margin accounts Form 1099. As noted above, the timing towards the minimum 61 days needed
where the broker has the discretion to of the passage of JGTRRA has placed a to qualify the dividends. [New York
use the customer’s stock for loans. If a heavy burden on brokers to adjust their State Bar Association, 2003, p. 276]
dividend is paid while the stock is out reporting processes to comply with the Hedging transactions that diminish risk
on loan, the broker replaces the divi- new law, and it is not likely that brokers of loss include selling short against the
dend with a “substitute” or “cash in- will accurately distinguish the payments box and putting a collar on the stock.5
lieu of” dividend. For non-tax purposes, for all investors. If substitute dividends An example of a short sale against the
the holding period of the customer’s are reported as qualified dividends on box occurs when an investor sells stock
stock is not broken; however, for tax the 2003 Form 1099, the IRS will allow that the investor must borrow, even
purposes, the loaning of the stock out of taxpayers to report these amounts as continued on page 8
TENNESSEE CPA JOURNAL: November 2004 7
Dividend Tax Cut Traps
continued from page 7
though the investor already owns iden- the ability to reduce the effective tax rate these foreign corporations are classified
tical stock. The IRS considers buying a on those dividends from 15 percent to are complex. However, in most
put option against stock already owned zero [Yang and Chang, 2004]. instances, investors and brokers can rely
to be equivalent to a short sale against upon the disclosures of the foreign cor-
the box. A put option allows an investor Trap #6: Many Dividends porations to determine their classifica-
to sell stock at a specified strike price, so Received from Foreign Corpo- tion status.
the investor’s downside risk is limited if rations are Not Qualified Div-
the investor already owns the stock. idends Conclusion
Putting a collar on a stock consists of The complex issues involving foreign For the 2003 filing season, the IRS has
buying a put option to cushion down- dividends that qualify for the preferen- indicated that investors can rely on their
side risk and selling or writing a call tial rate are outlined in Notice 2003-79. Form 1099 without penalty for the clas-
option to raise the funds to buy the put First, as with any potential dividend, the sification of qualified dividends and the
option. The downside of the stock collar security must pass the equity test, mean- availability of the preferential rates.
is that the call option limits upside gain. ing the dividend-paying security must However, the 2003 Form 1099s are
The benefit is that the collar is normally be in substance an equity investment unlikely to be a reliable predictor of
a cashless exercise in risk management, rather than a debt instrument. Second, what qualified dividends will be report-
but this hedge can mean that the divi- and also applicable to most dividend sit- ed on the 2004 Form 1099s. Tax prepar-
dends received from the owned stock uations, the distribution must satisfy the ers should make investors aware of this
may not qualify for the preferential earnings and profits test; that is, the cor- likelihood and should follow up with
rates. poration paying the dividend must have financial planning advice to mitigate
a positive accumulated or current earn- unpleasant surprises for the 2004 tax
Trap # 5: Qualified Divi- ings and profits balance, otherwise the year. The tax reduction on dividends
dends Are Not Included in distribution will be taxed as return of from JGTRRA is not only an opportuni-
Net Investment Income capital. Third, and unique to qualified ty for investors to increase after-tax
The same restrictions apply to qualified foreign dividends, the security must sat- returns, but is also an excellent opportu-
dividend income as apply to long-term isfy the readily tradable test or the com- nity for tax preparers to give their
capital gain income for purposes of cal- pany must satisfy the possessions or clients the value-added service of finan-
culating deductible investment interest.6 treaty test. Fourth, the company must cial planning to ensure that the reduced
Thus, if stock is purchased with bor- satisfy the foreign investment company rates will be realized on future divi-
rowed money and the dividends exclusion test. Finally, the investor must dends. ■
received are taxed at the preferential satisfy the holding period test. Only the
rate, the dividends will not be included third and fourth tests are considered References
in the calculation of net investment below. New York State Bar Association. “Dividends
income which will result in a lower ceil- The readily tradable test is described Provisions of the Jobs and Growth Tax
ing for the deductibility of investment in Notice 2003-71. Under this notice, a Relief Reconciliation Act of 2003,” Tax
interest expense than existed before foreign corporation is readily tradable if Notes, Vol. 101, No. 2 (Oct. 13, 2003), pp.
273-286.
2003. The purpose behind the restriction its common stock or its American
Yang, James G.S. and Chiaho Chang. “Not All
is to eliminate the possibility of a dou- depositary receipt, with respect to such Dividends Qualify for the Reduced Tax
ble benefit; that is, a preferential rate on stock, is listed on a national securities Rate,” Practical Tax Strategies/Taxation
the dividends received and an ordinary exchange that is registered, such as the for Accountants (March 2004). (Accessed at
income benefit on the deductibility of New York Stock Exchange, American www.riacheckpoint.com on March 11,
the investment interest expense. How- Stock Exchange or NASDAQ. The 2003 2004).
ever, the taxpayer can, by election, forgo treaty test is based upon the country of 1
IRC §1(h)(11)
the preferential rate on all or a part of incorporation. If the United States has a
2
IRC §1(h)(11)(B)(iii)
the dividends received and include only treaty with a limitation of benefits provi-
3
IRS Notice 2003-67
the qualified dividends taxed at ordi- sion with the country of incorporation,
4
Notice 2003-67 (9/16/2003)
5
IRC § 246(c)(4)
nary income rates as net investment the foreign corporation will normally sat- 6
IRC §163(d)(4)
income. For example, if an investor isfy this test. Notice 2003-69 lists coun-
earned $5,000 in qualified dividends tries that qualify for the treaty test. Most
and paid $500 in interest on a loan to treaty partners of the United States are About the authors
purchase the stock, the investor could listed in this notice, but there are four Bradley D. Childs, CPA, Ph.D., is an associ-
elect to report $500 of the dividends as notable exceptions: Bermuda, the ate professor of accounting at Belmont Uni-
ordinary income, offset this income with Netherlands Antilles, Barbados and a versity in Nashville, Tenn. He can be
a $500 investment interest expense group of certain former Soviet Republics. reached at childsb@mail.belmont.edu.
deduction and report the remaining The fourth test exempts from the defi- Marilyn Young, CPA, Ph.D., is an assis-
$4,500 as qualified dividends taxed at the nition of qualified dividends distribu- tant professor of accounting at Belmont
preferential rate. Electing to report an tions received from a foreign personal University in Nashville, Tenn. She can be
amount of the dividend equal to the holding company, a foreign investment reached at youngm@mail.belmont.edu.
interest paid as ordinary income creates company or a passive foreign invest-
ment company. The rules by which
8 TENNESSEE CPA JOURNAL: November 2004