Capitalizing on the Lower Dividend Tax Rate

The maximum tax rate on qualified dividends received by an individual, trust, or estate is 23.8% (base rate of 20% plus 3.8% net investment income tax for some high-income taxpayers). Dividends that would otherwise be taxed at the 10% or 15% ordinary income rate are taxed at 0% (essentially, they are not taxed). Thus, qualified dividends are taxed at the long-term capital gain rates. Identifying qualified dividends and helping taxpayers meet the requirements for qualified dividend status are valuable client services.

Qualified dividends are distributions of cash or property made by a domestic or qualified foreign corporation out of its earnings and profits (E&P) to a shareholder with respect to its stock (Secs. 1(h)(11)(B)(i) and 316). Therefore, distributions from domestic C corporations (to the extent of E&P) are generally qualified dividends. An S corporation, on the other hand, can have accumulated E&P only if it was formerly a C corporation or merged with a C corporation. Therefore, distributions from S corporations are often not qualified dividends because they are not made from E&P but instead represent a distribution of S corporation earnings. (However, qualified dividends that an S corporation receives are passed through to the shareholders and potentially taxed at the lower rates, regardless of whether the S corporation makes any shareholder distributions.)

Qualified Foreign Corporations

Qualified dividends include otherwise qualified dividends received from qualified foreign corporations. A corporation is a qualified foreign corporation if it is (1) incorporated in the United States or a U.S. possession, (2) readily tradable on an established U.S. securities market, or (3) eligible for benefits of a comprehensive income tax treaty with the United States that the Treasury secretary determines is satisfactory for purposes of the reduced tax rate on dividends and includes an exchange-of-information program (Sec. 1(h)(11)(C)).

Notice 2003-71 defines "readily tradable on an established securities market in the United States" to include common or ordinary stock, or an American depositary receipt in respect of such stock, if it is listed on the following securities exchanges: American Stock Exchange, the Boston Stock Exchange, the Cincinnati Stock Exchange, the Chicago Stock Exchange, the NYSE, the Philadelphia Stock Exchange, the Pacific Exchange Inc., or the Nasdaq Stock Market. (Several of these exchanges have merged or changed their names since the issuance of Notice 2003-71.)

Notice 2011-64 provides that the U.S. treaties with the following countries satisfy the requirements of Sec. 1(h)(11)(C): Australia, Austria, Bangladesh, Barbados, Belgium, Bulgaria, Canada, China, Cyprus, Czech Republic, Denmark, Egypt, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, India, Indonesia, Ireland, Israel, Italy, Jamaica, Japan, Kazakhstan, Korea, Latvia, Lithuania, Luxembourg, Malta, Mexico, Morocco, Netherlands, New Zealand, Norway, Pakistan, Philippines, Poland, Portugal, Romania, Russian Federation, Slovak Republic, Slovenia, South Africa, Spain, Sri Lanka, Sweden, Switzerland, Thailand, Trinidad and Tobago, Tunisia, Turkey, Ukraine, United Kingdom, and Venezuela. This list will be updated as appropriate. Note that a payer corporation must be eligible for the treaty benefits to be a qualified foreign corporation.

Dividends from a foreign corporation will not qualify for the reduced tax rate if they were paid by a foreign corporation that for the current or immediately prior tax year was a Sec. 552 foreign personal holding company, a Sec. 1246(b) foreign investment company, or a Sec. 1297 passive foreign investment company.

Any foreign tax credit allowed with respect to dividends eligible for the reduced tax rates will be scaled back under rules similar to those imposed by Sec. 904(b)(2)(B) relating to certain capital gains. This prevents the taxpayer from claiming a foreign tax credit greater than the U.S. tax paid on that income.

Passthrough Entities

Partnerships (including LLCs taxed as partnerships) pass qualified dividend income through to noncorporate partners, where the dividends are taxed at the favorable rates (Sec. 702(a)(5)). S corporations (including LLCs taxed as such) also pass through qualified dividends (received from corporations in which the S corporation holds stock) to their noncorporate shareholders because the character of a passthrough item from an S corporation is determined as if the passthrough item were realized directly from the source (Sec. 1366(b)). Also, qualified dividends received by a single-member LLC that is treated as a disregarded entity should be treated as if the LLC member received them.

Mutual Fund Dividends

Although most distributions from mutual funds (i.e., regulated investment companies) are referred to as dividends, mutual fund distributions will qualify for the reduced tax rate on dividends only to the extent the amount is attributable to qualified dividends received by the fund. To the extent mutual fund distributions are attributable to items such as interest and short-term capital gains, they will not qualify (although distributions attributable to long-term capital gains continue to qualify for the preferential long-term capital gain rate) (Sec. 1(h)(11)(D)(iii)).

A mutual fund must first meet a 61-day (or 91-day) holding period requirement (discussed below) with regard to a stock before treating the dividend it receives as a qualified dividend and reporting it as such to the shareholder (Sec. 854(b)(1)(B)). A mutual fund shareholder must also meet the holding period requirement with respect to the mutual fund shares it owns before any amount reported to it as a qualified dividend is eligible for the lower dividend rate. Thus, even though an amount is reported as a qualified dividend on Form 1099-DIV, Dividends and Distributions, it is not automatically eligible for the lower dividend rate unless the shareholder-level requirements (e.g., holding period, no obligation to repay, etc.) are also met with respect to the mutual fund shares.

Investors cannot assume that all dividends, even those that appear to be qualified dividends, are eligible for the reduced tax rate. Instead, certain transactions may render a dividend ineligible. This is especially true for investors who frequently trade securities or enter into more sophisticated financial transactions.

Nonqualified Payers

Dividends received from a tax-exempt (under Sec. 501 or 521) corporation (e.g., a farmers' cooperative) (including a corporation with that status for the year before the distribution) and dividends allowed as a deduction under Sec. 591 (relating to mutual savings banks and certain other savings institutions) do not qualify for the reduced tax rate.

Short Sales and Derivatives

Any dividend to the extent the taxpayer is obligated (because of a short sale or otherwise) to make related payments with respect to positions in substantially similar or related property is not a qualified dividend (Sec. 1(h)(11)(B)). This includes certain derivatives (i.e., financial contracts in which value or income is determined (or derived) at least in part on that of an underlying security or variable) such as a swap transaction, where the owner of the stock pays the dividends to a counterparty in return for a payment based on a different investment or index. This rule would also apply to investors who hold a long and short position in the same stock.

Disguised Interest

Taxpayers should pay particular attention to investments labeled as preferred stock. Many investments (e.g., trust preferred securities) have been marketed as such, even though the issuer treats them as debt and deducts the interest expense. Because the issuer's classification controls the investment's tax classification (Sec. 385), if the issuer deducts interest paid to investors, the owner cannot treat the investment as stock for purposes of the reduced tax rate. Taxpayers might find the prospectus or even certain websites (e.g., quantumonline.com) helpful in determining whether an investment is a true dividend-paying preferred stock, but in some cases it may be necessary to contact the broker or issuing company to be sure.

REIT Distributions

Because real estate investment trusts (REITs) normally invest in real estate and pay no entity-level tax, they will rarely pay dividends eligible for the reduced rates. However, to the extent they are attributable to (a) dividends the REIT received from taxable non-REIT corporations or (b) income on which the REIT paid tax (e.g., undistributed income) less the amount of tax the REIT paid on that income, REIT distributions should qualify for the lower rate.

Holding Period Requirement

Dividends are not eligible for the reduced tax rates unless the shareholder holds the underlying shares for a certain period of time revolving around the stock's ex-dividend date. A stock's ex-dividend date is the day it begins trading without rights to an announced, but as yet unpaid, dividend. To qualify for the reduced rate on dividends, a shareholder must hold the stock for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date (Sec. 1(h)(11)(B)(iii)). For preferred stock dividends attributable to a period or periods aggregating more than 366 days (e.g., cumulative preferred stock with dividends in arrears), the holding period is more than 90 days during the 181-day period beginning 90 days before the stock's ex-dividend date. Preferred stock not subject to this special rule is subject to the regular 61-day holding period rule. The holding period includes the date of disposition, but not the acquisition date (Sec. 246(c)(3)).

To receive the dividend, the taxpayer must own the stock at least one day before the ex-dividend date. Because the required holding period is more than 60 days during a period beginning 60 days before the ex-dividend date, this necessarily means that the holding period must include the ex-dividend date. However, the 61-day (or 91-day) holding period does not have to be consecutive. Also, certain transactions that limit the taxpayer's risk of loss with respect to the stock (e.g., the taxpayer has made and not closed a short sale) toll the taxpayer's holding period until those transactions are closed (Sec. 246(c)(4)).

Example 1. Required holding period for the reduced rate on dividends:

A purchased 100 shares of B Corp. common stock on Oct. 15, 2015. B declared and paid one dividend in 2015. The stock's ex-dividend date was Nov. 1, 2015, and the dividend was paid on Nov. 19, 2015. Therefore, the required 61-day holding period for the Nov. 19 dividend would have to be satisfied between Sept. 2, 2015 (60 days before the ex-dividend date), and Dec. 31, 2015 (end of the 121-day period).

If A sold her stock on Dec. 2, 2015, and did not repurchase any B shares, the dividend would not qualify for the reduced rate because she held her stock for less than 61 days. However, if she repurchases 100 shares of B stock after Dec. 2, 2015, and holds it for at least 15 days before Jan. 1, 2016, she will hold the stock for the required 61 days, qualifying the dividend for the reduced tax rate.

Payments in Lieu of Dividends

When the owner of stock lends that stock to a short seller (who uses it to cover a short sale), any dividends paid while the loan is outstanding are paid to the short seller's buyer. To compensate the lender of the stock for the missed dividend, the short seller pays him or her a payment in lieu of dividends. This payment is not a dividend and does not qualify for the reduced tax rate. Most standard brokerage agreements allow the broker to lend out stock held in a margin account. In the past, investors were generally indifferent (and often unaware) that their stock was lent out, since it did not affect the amount they received, and dividends and payments in lieu were taxed at the same rate.

Example 2. Payments in lieu of dividends: C's margin account with D Brokers holds 500 shares of E Bank Inc., her only investment. F, also a customer of D Brokers, owns no E Bank stock, but wants to sell 500 shares short. He believes E Bank's stock price will fall and he will be able to cover his short position profitably. To facilitate the short sale on Jan. 4, 2015, D Brokers borrows 500 shares of E Bank stock from C's account and sells it in F's account. On Oct. 3, 2015, F covers his short position, and the E Bank stock is restored to C's account. C was unaware of these transactions.

During 2015, E Bank declared and paid quarterly dividends of $1 per share on C's stock totaling $2,000 (500 shares × $1 × 4 quarters) for the year. While the short sale was open, F was required to pay C substitute dividends totaling $1,500 (500 shares × $1 × 3 quarters). In January 2016, C receives a composite substitute statement Form 1099-DIV from D Brokers indicating that in 2015 she received $500 in qualified dividends and $1,500 in substitute payments in lieu of dividends that are not eligible for qualified dividend treatment.

An investor holding dividend-paying stocks in street name (i.e., in the broker's name rather than in his or her own name) risks the stocks' being lent by the broker and, thus, receiving payments in lieu of dividends that do not qualify for the preferential dividend tax rate. To reduce or eliminate this risk, an investor should (1) make sure he or she understands his or her brokerage agreement and whether it allows shares to be loaned, (2) place dividend-paying stock in a cash account rather than a margin account since brokers typically cannot loan shares held in cash accounts, and (3) require that the broker obtain his or her approval before loaning shares (and if the broker will not agree, consider changing brokers).

Investment interest expense is deductible as an itemized deduction but only to the extent of net investment income (Sec. 163(d)(1)). Qualified dividend income is not treated as investment income for purposes of Sec. 163 (Sec. 1(h)(11)(D)(i)). However, taxpayers can elect to treat qualified dividend income as investment income (Sec. 163(d)(4)(B)). If the election is made, the dividends treated as investment income will not qualify for taxation at the reduced rates. (A similar rule applies to long-term capital gains.) This gives taxpayers the choice of applying the favorable tax rates to dividend income or using qualified dividend income to offset investment interest expense.

Planning tip: This election generally is not beneficial unless the taxpayer has no current or anticipated sources of investment income (other than the elected dividend) and thus does not expect to be able to deduct his or her investment interest expense any time in the foreseeable future. Even then, practitioners should run the numbers to determine the benefit of deducting the interest expense and additional tax due for taxing the dividend at the ordinary income rates.

A stock redemption occurs when a corporation acquires its stock from a shareholder in exchange for property (including cash), whether the stock acquired by the corporation is canceled, retired, or held as treasury stock (Sec. 317(b)). A redemption may be treated as a dividend distribution to the shareholder or as a sale or exchange transaction. If it is a dividend, the distribution is taxed to the shareholder as ordinary income to the extent of the corporation's earnings and profits (E&P). Amounts distributed in excess of E&P are treated first as a return of capital to the extent of shareholder basis, then as capital gain (Sec. 301(c)).

If the redemption qualifies as a sale or exchange, the shareholder is taxed on a capital gain equal to the excess of the distribution over the shareholder's basis in the stock surrendered. A redemption qualifies as a sale or exchange (i.e., a capital gain transaction) if it meets one of the following five criteria (Sec. 302(b)):

1. It is made in complete termination of the shareholder's interest;
2. It is a substantially disproportionate redemption;
3. It is not essentially equivalent to a dividend;
4. It represents a partial liquidation of the corporation; or
5. It represents stock acquired from an estate or beneficiary, to the extent of estate taxes and administration expenses.

Observation: Because the constructive ownership rules apply in determining stock ownership under Sec. 302(b), sale or exchange treatment is sometimes difficult to achieve, especially for closely held family-owned corporations. With qualified dividends being taxed at the preferential capital gain rates, redeemed shareholders will often be less concerned with whether the redemption is treated as a sale or exchange or as a dividend. However, there are situations (such as when the taxpayer has significant basis in the redeemed stock, or capital loss carryovers) where sale or exchange treatment is still preferable to a dividend.

When a complete redemption fails to satisfy any of the Sec. 302(b) tests for sale or exchange treatment and is therefore taxed as a dividend, what happens to the tax basis in those redeemed shares? If the redeemed shareholder actually owns some stock in the corporation after the redemption, the basis of the redeemed shares is added to the basis of the remaining shares (Regs. Sec.1.302-2(c), Examples (1) and (3)). If the shareholder does not actually own any shares after the redemption, the basis of the redeemed shares is transferred to the shares of a related taxpayer, if shares owned by that related taxpayer were attributed to the redeemed shareholder (Regs. Sec. 1.302-2(c), Example (2)). Generally, this would appear to be a reasonable adjustment. However, if the related person's relationship with the redeemed owner is unfriendly (e.g., a spouse who later is divorced), the basis adjustment may never benefit the redeemed shareholder and, indeed, could provide a tax benefit to someone the redeemed shareholder has no intention of benefiting.

Example 3. Basis of redeemed shareholder shifted to a related party: G and her husband H each own 50% of I Inc.'s outstanding stock. Both have $50,000 basis in their stock. I has $10 million of earnings and profits. All of G's stock is redeemed for $4 million. Assume she does not elect to waive family attribution. H's ownership is attributed to her, so she cannot meet any of the Sec. 302(b) tests for sale or exchange treatment. The redemption proceeds are treated as a nonliquidating distribution. G recognizes $4 million of dividend income. Her $50,000 basis in her stock is added to H's basis in I.

A redeemed shareholder who has held his or her stock for one year or less would normally prefer dividend rather than sale or exchange treatment. Here, sale or exchange treatment would result in a short-term capital gain taxed at higher ordinary rates than the preferential capital gain rate that applies to qualified dividends (assuming the 61-day or 91-day holding period for a qualified dividend is met).

This case study has been adapted from PPC's Tax Planning Guide—Partnerships, 29th Edition, by William D. Klein, Sara S. McMurrian, Linda A. Markwood, Cynthia Zatopek, Sheila A. Owen, and M. Andrew Vance, published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2015 (800-431-9025; tax.thomsonreuters.com).