Dividends and other corporate distributions

06 Dec, 2015 TAX LAW 56

Chapter 8
Dividends and other corporate distributions

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Introduction

Most people think they know what dividends are. The problem is that the term is commonly used to describe a large number of items that the IRS does not consider to be dividends. “Dividends” paid by an insurance company to its policyholders are considered by the IRS to be a return of premiums, not dividends. “Dividends” paid by a savings and loan association to its depositors are considered to be interest, not dividends.

So what is a dividend? A dividend is a share of a corporation’s profits that is distributed to shareholders. This chapter discusses how these distributions, as well as other corporate distributions, are taxed.

If you own stock in a company or shares in a mutual fund or real estate investment trust (REIT), you may receive dividend distributions. The distributing company or mutual fund will send you a Form 1099-DIV just after year-end with the total amount of dividends you must report to the IRS on your income tax return. This chapter explains the difference between the various tax forms you may receive and which forms to keep in your records or attach to your income tax return.

This chapter also discusses dividend reinvestment plans (DRPs) that reinvest the dividends in the stock generating them. These plans are provided by companies for all their shareholders and should not be confused with retirement plans run by employers for the benefit of their employees.

Certain dividend income (but not interest income), referred to as “qualified dividend income,” is taxed at a maximum rate of 20% for high income taxpayers who are otherwise in the 39.6% regular income tax bracket (i.e., taxable incomes over $406,750 for individual filers, $432,200 for heads of households, $457,600 married filing jointly, and $228,800 if married filing separately). Qualified dividends received by taxpayers in the 10% and 15% tax brackets are taxed at a zero rate. For all others, the tax rate on qualified is 15%. These preferential tax rates on qualified dividend income apply to both the regular tax and the alternative minimum tax.

Under the Affordable Care Act, the 3.8% Net Investment Income Tax (NIIT) on unearned income—including dividends—took effect for tax years beginning in 2013 and thereafter. For individuals, the tax is 3.8% of the lesser of: (1) “net investment income” or (2) the excess of modified adjusted gross income (MAGI) over $200,000 ($250,000 if married filing jointly or a qualifying widow(er) with dependent child; $125,000 if married filing separately). The NIIT is payable regardless of whether or not you otherwise pay any regular income tax or are subject to alternative minimum tax on your income.

Tax Breaks and Deductions You Can Use Checklist

Qualified dividend income. Taxpayers in the highest regular tax bracket of 39.6% are subject to a maximum tax rate of 20% on qualified dividend income. On the other hand, taxpayers who are in the 10% and 15% tax brackets have a zero percent tax rate applied to qualified dividend income. For taxpayers in the other regular tax brackets, the top rate on qualified dividends is 15%. (The top tax rates on long-term capital gains are the same as those for qualified dividends. See chapter 16, Reporting gains and losses, for more information.) The twist is that not all dividend income is “qualified,” so look carefully before you invest. For example, most income from money market funds is not qualified dividend income. Dividends from foreign corporations, on the other hand, may be qualified.

Foreign dividends. If you received dividends on foreign corporation stock that you own, it’s likely that the corporation withheld foreign tax on those payments. Don’t report the net amount on your tax return. Instead, you should report the full amount of the dividend (before withholding) and claim the foreign tax withheld either as a credit or as a deduction on your return. See chapter 23, Taxes you may deduct, and chapter 37, Other credits including the earned income credit.

Life insurance dividends. “Dividends” paid out on life insurance policies are not taxable income. They are actually considered to be a return of your premiums. You should not report them on your return unless their total is more than your accumulated premiums.

Dividends used to buy more stock. If you invest in stock and choose to have the dividends reinvested to purchase additional stock, your basis in the stock is increased by the amount of dividends reinvested. The dividends are taxable to you even though you did not receive the cash, but the basis of your stock is increased by the amount of the dividends reinvested. When the stock is sold, don’t forget to increase your basis by the amount of the dividends reinvested.

Reminder

Foreign-source income. If you are a U.S. citizen with dividend income from sources outside the United States (foreign-source income), you must report that income on your tax return unless it is exempt by U.S. law. This is true whether you reside inside or outside the United States and whether or not you receive a Form 1099 from the foreign payer.

TAXALERT

Dividends received by an individual shareholder from domestic corporations and “qualified foreign corporations” are eligible for the same reduced federal tax rate as net capital gain income. These reduced rates apply for both the regular tax and the alternative minimum tax.

Thus, these dividends are taxed at a maximum rate of 20% for taxpayers who are in the top 39.6% tax bracket (i.e., taxable incomes over $406,750 for individual filers, $432,200 for heads of households, $457,600 married filing jointly, and $228,800 if married filing separately). Qualified dividends received by taxpayers subject to tax brackets of 15% or lower are taxed at 0%. Qualified dividends received by taxpayers in the other regular income tax brackets (i.e., 25%, 28%, 33%, or 35%) are taxed at 15%.

This reduced tax rate only applies to dividends from common shares held for more than 60 days during the 121-day period beginning 60 days before the ex-dividend period. (The ex-dividend date is the date that determines whether the seller, rather than the buyer, receives the announced dividend.) Hence, this provision combined with the 20% top rate on long-term capital gains makes short-term investing less tax-efficient.

Example

You purchase dividend-paying common stock on February 1 and sell it November 1. The company declares dividends on March 31, June 30, and September 30. The lower tax rates apply to all dividends because you held the stock for more than 60 days out of the 121-day period that began 60 days in advance of each ex-dividend date. If you purchase stock on March 1 and sell it on April 15, a March 31 dividend would not qualify for the lower tax rates because you did not hold it for more than 60 days.

Under the Affordable Care Act, the new 3.8% Net Investment Income Tax on unearned income took effect for tax years beginning after December 31, 2012. For individuals, the tax is 3.8% of the lesser of: (1) “net investment income” (NII) or (2) the excess of modified adjusted gross income (MAGI) over $200,000 ($250,000 if married filing jointly or a qualifying widow(er) with dependent child; $125,000 if married filing separately). NII includes dividends, as well as interest income and other items.

This combination of a higher qualified dividend tax rate of 20% and the new 3.8% Medicare contribution tax that took effect in 2013 raised the top tax rate on dividend income to 23.8%. Compared to the 15% top rate on qualified dividend income that was in effect in 2012, a 23.8% combined tax rate represents a 59% increase over the tax rate in 2012.

This chapter discusses the tax treatment of:

Ordinary dividends,
Capital gain distributions,
Nondividend distributions, and
Other distributions you may receive from a corporation or a mutual fund.

This chapter also explains how to report dividend income on your tax return.

Dividends are distributions of money, stock, or other property paid to you by a corporation or by a mutual fund. You also may receive dividends through a partnership, an estate, a trust, or an association that is taxed as a corporation. However, some amounts you receive that are called dividends are actually interest income. (See Dividends that are actually interest under Taxable Interest in chapter 7.)

Most distributions are paid in cash (or check). However, distributions can consist of more stock, stock rights, other property, or services.

EXPLANATION

Any distribution to a shareholder from earnings and profits is generally a dividend. However, a distribution is not a taxable dividend if it is a return of capital to the shareholder. Most distributions are in the form of money, but they may also be in stock or other property.

An interest-free loan or below-market rate loan by a corporation to a stockholder may result in taxable dividend income to the stockholder.

Additionally, if you are a stockholder who uses company property for personal use, you are considered to be in constructive receipt of a dividend that will be taxable to you and disallowed as a tax deduction to the company. The value of a constructive dividend is the fair market value of the benefit provided to the shareholder.

Example 1

A shareholder’s use of a condominium maintained by his solely owned corporation resulted in his receipt of constructive dividends because he maintained the unit as his residence. The taxpayer benefited from the corporation’s payments because he did not have to pay any housing costs. The Tax Court determined the portion of the condominium expenses that was allocable to business use and permitted the corporation to deduct that amount. The balance of the expenses was treated as constructive dividends received by the shareholder.

Example 2

A corporation sold real property to its sole shareholder at a price lower than the property’s fair market value. The result is a constructive dividend to the shareholder of the difference between the fair market value and the purchase price, and is treated as a gain for the corporation.

Useful Items

You may want to see:

Publication

514 Foreign Tax Credit for Individuals
550 Investment Income and Expenses

Form (and Instructions)

Schedule B (Form 1040A or 1040) Interest and Ordinary Dividends
8960 Net Investment Income Tax—Individuals, Estates, and Trusts

TAXPLANNER

Records you should keep. The following is a list of records that you should keep to substantiate your dividend figures in the event of an IRS or state examination. Generally, we recommend that you retain these records for at least 6 years. However, you should keep records related to dividend reinvestment programs for 6 years after you fully exit the program.

1099-DIV, Dividends and Distributions
Dividend Reinvestment Plan Records
Form 2439, Notice to Shareholders of Undistributed Long-Term Capital Gains
1099s with backup withholding for attachment to your tax return
Form 1096, Annual Summary and Transmittal of U.S. Information Returns
Schedule K-1 (Form 1041), Beneficiary’s Share of Income, Deductions, Credits, etc.
Schedule K-1 (Form 1065), Partner’s Share of Income, Credits, Deductions, etc.
Schedule K-1 (Form 1120S), Shareholder’s Share of Income, Credits, Deductions, etc.

General Information

This section discusses general rules for dividend income.

Tax on unearned income of certain children. Part of a child’s 2014 unearned income may be taxed at the parent’s tax rate. If it is, Form 8615, Tax for Certain Children Who Have Unearned Income, must be completed and attached to the child’s tax return. If not, Form 8615 is not required and the child’s income is taxed at his or her own tax rate.

Some parents can choose to include the child’s interest and dividends on the parent’s return if certain requirements are met. Use Form 8814, Parents’ Election To Report Child’s Interest and Dividends, for this purpose.

For more information about the tax on unearned income of children and the parents’ election, see chapter 32.

Beneficiary of an estate or trust. Dividends and other distributions you receive as a beneficiary of an estate or trust are generally taxable income. You should receive a Schedule K-1 (Form 1041), Beneficiary’s Share of Income, Deductions, Credits, etc., from the fiduciary. Your copy of Schedule K-1 (Form 1041) and its instructions will tell you where to report the income on your Form 1040.

Social security number (SSN) or individual taxpayer identification number (ITIN). You must give your SSN or ITIN to any person required by federal tax law to make a return, statement, or other document that relates to you. This includes payers of dividends. If you do not give your SSN or ITIN to the payer of dividends, you may have to pay a penalty.

For more information on SSNs and ITINs, see Social Security Number (SSN) in chapter 1.

Backup withholding. Your dividend income is generally not subject to regular withholding. However, it may be subject to backup withholding to ensure that income tax is collected on the income. Under backup withholding, the payer of dividends must withhold, as income tax, on the amount you are paid, applying the appropriate withholding rate.

Backup withholding may also be required if the IRS has determined that you underreported your interest or dividend income. For more information, see Backup Withholding in chapter 4.

Stock certificate in two or more names. If two or more persons hold stock as joint tenants, tenants by the entirety, or tenants in common, each person’s share of any dividends from the stock is determined by local law.

Form 1099-DIV. Most corporations and mutual funds use Form 1099-DIV, Dividends and Distributions, to show you the distributions you received from them during the year. Keep this form with your records. You do not have to attach it to your tax return.

Dividends not reported on Form 1099-DIV. Even if you do not receive Form 1099-DIV, you must still report all your taxable dividend income. For example, you may receive distributive shares of dividends from partnerships or S corporations. These dividends are reported to you on Schedule K-1 (Form 1065), Partner’s Share of Income, Deductions, Credits, etc., and Schedule K-1 (Form 1120S), Shareholder’s Share of Income, Deductions, Credits, etc.

Reporting tax withheld. If tax is withheld from your dividend income, the payer must give you a Form 1099-DIV that indicates the amount withheld.

Nominees. If someone receives distributions as a nominee for you, that person should give you a Form 1099-DIV, which will show distributions received on your behalf.

EXPLANATION

A nominee is someone who, in his or her name and with his or her social security or federal identification number, receives income that belongs to another person. Form 1099 is used by the nominee to report the amount and type of income received on behalf of the owner.

If you receive a Form 1099 from a nominee, you should cite the source of that income on your tax return as the nominee, not the original payer of the income. If you receive a Form 1099 as a nominee for another person, see the section on Nominees under How to Report Dividend Income, toward the end of this chapter, for a complete discussion on the filing and reporting requirements of a nominee.

Example

Brokerage Firm A collects your dividend from XYZ Corporation and reports the income to you on Form 1099. You should show the dividend as being received from Brokerage Firm A, not from XYZ Corporation.

Form 1099-MISC. Certain substitute payments in lieu of dividends or tax-exempt interest received by a broker on your behalf must be reported to you on Form 1099-MISC, Miscellaneous Income, or a similar statement. See Reporting Substitute Payments under Short Sales in chapter 4 of Publication 550 for more information about reporting these payments.

Incorrect amount shown on a Form 1099. If you receive a Form 1099 that shows an incorrect amount (or other incorrect information), you should ask the issuer for a corrected form. The new Form 1099 you receive will be marked “Corrected.”

Dividends on stock sold. If stock is sold, exchanged, or otherwise disposed of after a dividend is declared but before it is paid, the owner of record (usually the payee shown on the dividend check) must include the dividend in income.

Tags: EY Tax Guide 2015