Taxation of Ordinary and Qualified Dividends

Ordinary dividends are distributions of money, stock, or other property to holders of an ownership interest in the distributor. The most common issuers of dividends are corporations and mutual funds, but the issuer can also be a partnership, estate, or trust.

Dividends are reported to the Internal Revenue Service (IRS) and to the receivers of the dividends on Form 1099-DIV, Dividends and Distributions. Some distributions that are called dividends are actually considered interest, such as the distributions received from building and loan associations, cooperative banks, savings and loan associations, credit unions, and mutual savings banks. These distributions are reported on Form 1099-INT, Interest Income. Interest in the form of an original issue discount, such as original issue bonds sold for less than par value, is reported on Form 1099-OID, Original Issue Discount.

Other distributions, or portions thereof, often referred to as dividends are actually the return of invested capital, which is nontaxable, or may consist of capital gains. Distribution from life insurance policies (not modified endowment contracts) are treated as a nontaxable return of premium, but distributions exceeding the total premiums paid are taxable.

If dividends are reinvested in more shares of the company instead of receiving cash, it is still taxable. If the company has a dividend reinvestment program that allows the shareholder to reinvest the dividends by buying additional shares at discounted prices, then the difference between the fair market value of the shares minus the discounted prices is taxable as a dividend, in addition to the dividends that were used to purchase the discounted stock.

Ordinary and Qualified Dividends

Ordinary dividends are considered ordinary income, not capital gains, and are taxed as such. However, qualified dividends are taxed at the same marginal rate as net long-term capital gains: 0%, 15%, and 20%. The dividends of each type are reported separately on Form 1099-DIV, Dividends and Distributions. The 0% rate applies to lower income taxpayers where the top marginal tax rate on ordinary income is less than 25%; otherwise the 15% rate applies. Starting in 2013, qualified dividends will be subject to a marginal tax rate of 20% for those in the 39.6% bracket plus the 3.8% Medicare surtax. The 3.8% Medicare surtax will also apply to the 15% qualified dividend rate for those who earn more than the income threshold for that tax (single and head of household: $200,000; married filing jointly: $250,000).

Another advantage: qualified dividends, like tax-exempt interest, but unlike ordinary dividends, do not contribute to adjusted gross income (AGI) on Form 1040, so they do not increase the likelihood that some tax benefits may be restricted or eliminated because of income limitations.

Qualified dividends must satisfy the following requirements:

If the dividend is a qualified dividend, then it will be reported as such on Form 1099-DIV.

If the dividend comes from a mutual fund or exchange traded fund, then both the fund and the shareholder must both satisfy the holding period requirement. However, some funds may list the dividend as qualified if they satisfy the holding period requirement, even if the shareholder does not satisfy the requirement. In this case, the shareholder has to treat the income as ordinary income.

There are some dividends that are disqualified by IRS rules, including:

Some companies and most mutual funds have dividend reinvestment plans that allow the shareholder to reinvest the dividend by buying more shares of the company or fund. Although the dividends are reinvested, they must still be reported as income. If the reinvestment plan also allows the shareholder to buy more stock at less than fair market value, then the difference between the fair market value of the stock and the purchase price must also be reported as income.

Other Distributions

Capital gain distributions received from a mutual fund or other regulated investment company, or a real estate investment trust (REIT) should be reported as long-term capital gains regardless of how long the shareholder held the shares. Sometimes these distributions are not paid to the shareholder, but are retained by the company to reinvest. However, these capital gains still have to be reported by the shareholder even though they were not received. The shareholder will be notified by a Form 2439, Notice to Shareholder of Undistributed Long-Term Capital Gains.

A non-dividend distribution is a return of invested capital, which is reported on Form 1099-DIV. A non-dividend distribution reduces the tax basis of the stock; thus, taxes are not paid until the stock is sold. The tax basis of the earliest purchased stock is reduced first, until the basis of all stock reaches zero. Any additional nondividend distributions must be reported as a capital gain.

Example: You buy mutual fund shares for $100, and receive a nondividend distribution of $70, then your basis is now $30. If you sell the shares for $110, your profit will be $80.

Liquidating distributions, which are sometimes called liquidating dividends, or a return of capital, results from the partial or complete liquidation of the corporation. Liquidating distributions reduce the tax basis of the stock. If the distribution results in the redemption or cancellation of the stock, then the taxpayer may have a capital loss.

Like stock splits, stock dividends and stock rights are generally not taxable, since they are just increasing the number of outstanding shares of stock, which decreases the value of each individual stock accordingly. However, stock dividends and rights may be taxable if:

Constructive distributions, such as preferred stock redeemable at a premium to the issue price or where the conversion ratio was increased, are also taxable.

Dividends from stripped preferred stock are treated as ordinary income.

Because many stockholders will not own enough shares to receive a full share of stock in a dividend or rights distribution, the company will sometimes sell the shares and divide the proceeds among the stockholders, which is treated as a stock redemption by the corporation, resulting in a taxable distribution equal to the amount of cash received by the stockholder minus the basis of the fractional share sold. The capital gain or loss is reported on Form 8949, Sales and Other Dispositions of Capital Assets and Schedule D, Capital Gains and Losses.

Some corporations issue so-called script dividends, based on a script certificate that entitles the stockholder to a fractional share of the corporation. Script dividends are generally not taxable unless the corporation sells it and gives the stockholder the proceeds. The income will be equal to the income received minus the basis allocated to the certificate. If the certificate is redeemable for cash, then its fair market value is taxable income as of the date it is received.

Dividends received as property — sometimes referred to as dividend in kind — are taxable on the fair market value of the property.

Any corporate benefit conferred on shareholders, usually done by a closely held corporation, are treated as a constructive dividend, which is taxable at its fair market value.

Some dividends are not taxable, including:

Nominee Dividend Distributions

If the taxpayer serves as a nominee for a dividend distribution, i.e., receiving the dividend that belongs to someone else, such as for stock held in a joint account, and the other person is not the nominee's spouse, then the nominee recipient must send a separate Form 1099-DIV to the beneficial owner of the dividend no later than January 31, so that the owner can report the dividend on his own tax return. The nominee must file Form 1096, Annual Summary and Transmittal of U.S. Information Returns with the IRS by the end of February, or by the end of March, if filing electronically. On the nominee's tax return, the nominee portion of the dividends is subtracted from the total dividends on Schedule B, Interest and Ordinary Dividends, yielding the taxable portion to be reported on Form 1040.

Reporting Dividend Income

Dividends of $1,500 or less are reported on Form 1040 or 1040A. Dividends greater than $1,500 or a nominee receiving any amount of dividends that actually belong to someone else must file Schedule B, Interest and Ordinary Dividends and attach it to Form 1040. Dividends are reported on Form 1099-DIV, although some dividends that are actually interest will be reported on Form 1099-INT.

Dividends are reported for the year when they are received. However, dividends declared during October through December by a mutual fund or REIT are taxable for that year, even if the dividend is not actually received until the following year.

Return of capital distributions are not taxable, except for any excess of the distributions over the stock basis of the shareholder. The shareholder reduces the basis of his stock by the amount of the distribution, but not below 0. Any excess distribution is reported as a capital gain on Schedule D, Capital Gains and Losses; whether the gain is long-term or short-term depends on whether the shareholder held the stock longer than one year.

Dividends paid by insurance companies based on their policies are usually a return of premium, which is not taxable unless the distribution exceeds the total premiums paid by the policyholder. However, these dividends are taxable if they were claimed as a business expense in prior years, in which case they are included as business income when received. Dividends of capital stock of insurance companies are taxable. If the policyholder left the dividends with the insurance company to earn interest, then the interest is taxable. However, dividends paid by VA insurance is never taxable, nor is any interest earned by the dividends.

If the taxpayer received dividends from restricted stock for services performed either as an employee or independent contractor, then these dividends must be reported as wages rather than as dividend income.