Taxation of Qualified Dividends

Taxation of "Qualified Dividends"

Special Tax Rate on Dividends

The federal income tax rates on "qualified dividends" are the same as the rates on long-term capital gains. In 2013 and going forward, qualified dividends are also subject to the net investment income tax of 3.8%.

Qualified Dividends

Dividends eligible for the special tax rate are those received from domestic corporations and certain qualifying foreign corporations whose stock is traded on a U.S. securities exchange or other established market. A dividend is generally a corporate distribution to shareholders, based on their stock holdings, made out of current or accumulated earnings and profits, unless the distribution is specifically treated as a non-dividend by tax law (e.g., as a redemption or liquidation distribution).

Dividends that pass through to individuals from regulated investment companies may be eligible for the reduced tax rate on dividends. Mutual fund dividends will be eligible only to the extent they represent dividends the mutual fund earned on stock, and not on other types of fund earnings such as interest. Mutual funds will report to individual investors the portion of their dividends eligible for the reduced rates.

Ineligible Dividends

The special tax rates do NOT apply to dividends paid by, among other things:

$image\bullet.jpg$ Mutual insurance companies

$image\bullet.jpg$ Credit unions, mutual savings banks, savings and loans, and certain other types of financial institutions

$image\bullet.jpg$ Nonprofit voluntary employee beneficiary associations (VEBAs)

$image\bullet.jpg$ Employer securities owned by an employee stock ownership plan ( ESOP) to the extent the dividends are deductible under IRC Sec. 404(k)

$image\bullet.jpg$ Stock purchased with borrowed funds when the dividend was included in investment income for purposes of claiming an investment interest deduction

$image\bullet.jpg$ Tax-exempt corporations under IRC Sections 501 or 521

$image\bullet.jpg$ Farmers’ cooperatives

$image\bullet.jpg$ Foreign personal holding companies

$image\bullet.jpg$ Foreign investment companies

$image\bullet.jpg$ Passive foreign investment companies

$image\bullet.jpg$ Stock owned for 60 days or less in the 120-day period beginning 60 days before the ex-dividend date (when the corporation makes final the shareholders who will receive the dividend).

The special tax rates also do NOT apply to:

$image\bullet.jpg$ Payments received in lieu of dividends when shares are loaned out (this may occur when shares are held in an account with a margin agreement)

$image\bullet.jpg$ Dividends received in an IRA or qualified retirement plan

$image\bullet.jpg$ Any dividend to the extent the taxpayer is under an obligation to make related payments with respect to positions in substantially similar or related property

It appears that dividends on preferred stock will NOT be eligible for the special tax rate if the issuing corporation follows the common practice of (1) treating the preferred stock as debt on its books, and (2) deducting the "dividends" on such stock as interest.

Planning Considerations

In the past, owners of closely held C corporations often tried to take money out of the corporation as (reasonable) compensation rather than dividends, because the corporation could deduct the former but not the latter. And that's still true. However, compensation can now be taxed to individual owners at federal rates up to 37%, while qualified dividends are taxed as high as 20%. Moreover, dividends are not subject to payroll taxes, unlike compensation. However, another consideration is the 3.8% investment income tax on high income taxpayers, which would apply to dividend income. On the other hand, retirement plan contributions or benefits may be reduced if dividends are taken instead of compensation. Balancing the tax advantages and disadvantages of dividends vs. compensation is more complicated.

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