Dividends are taxed at the same 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).
