What Types of Dividends Qualify for the Reduced Tax Rates?

By: Tyler B. Korn, Esq.

It has come to our attention that the recently enacted Jobs and Growth Tax Relief Reconciliation Act of 2003 (the “2003 Act”) has created a significant amount of confusion amongst taxpayers and corporate attorneys alike.

As a result of the 2003 Act, dividends are now taxed at the same maximum 15 percent rate as capital gains. However, not all corporate distributions of profit qualify for the reduced tax rate, despite being labeled as dividends.

I. General Disqualifiers: Certain general disqualifiers can preclude qualification for the reduced rates. Most significantly, the reduced dividend rates only apply to stock held at least 60 days in the 120-day period beginning 60 days before the ex-dividend date. The reduced rates are also not available for dividends to the extent that the taxpayer is obligated to make related payments (as a result of a short sale, for example) with respect to positions in substantially similar or related property. And payments received in lieu of dividends from securities lending transactions, short sales, and similar transactions will not constitute qualified dividend income.

II. S Corporations: S Corporation distributions of profit generally will not qualify as dividends for purposes of the 2003 Act. A dividend is defined as a corporate distribution to shareholders from earnings and profits. Although an S Corporation is a true corporation, its earnings and profits are directly allocated to shareholders for purposes of pass-through taxation. If S Corporation dividends had been made to qualify for the reduced tax rate, the 2003 Act would have caused most taxpayers to entirely forego use of partnership tax classification (partnership distributions do not qualify for the reduced tax rate), at least until the 2003 Act’s date of sunset on January 1, 2009.

III. REITs: For similar reasons, most (but not all) REIT distributions will fail to qualify for the 2003 Act’s reduced tax rates for dividends.

IV. Preferred Stock versus Hybrid Preferred: It is often the case for tax purposes that stock labeled as “preferred stock” is not stock at all, but rather constitutes debt. Two reasons exist for this phenomenon. First, the distinction between debt and equity is often inadvertently blurred as a result of organizational documents being prepared without tax counsel. Second, equity is frequently intentionally made to constitute debt in order to enable issuing companies to deduct the distributions as interest expense. If a taxpayer holds preferred stock that constitutes debt for tax purposes (known as “hybrid preferred”), the taxpayer will not be entitled to benefit from the 2003 Act’s reduced tax rates for dividends.

V. Mutual Funds and Money Market Funds: Mutual fund companies generally distinguish between dividends and capital gains passed through to fund holders. Although dividends are now taxed at the same rate as capital gains as a result of the 2003 Act, capital gains and dividends still must be segregated and reported separately. Taxpayers must still net capital gains and losses against each other without taking dividends into account. Moreover, because interest will continue to be taxed at ordinary income rates, mutual fund companies are expected to begin distinguishing their interest-paying funds from their dividend and capital gain paying funds. Amounts received from money market funds will continue to be classified as interest, and therefore will also continue to be taxed at ordinary income rates.

VI. Retirement Accounts: The 2003 Act did not extend the dividend tax rate reduction to retirement accounts. Dividends earned on stock held in qualified retirement accounts will therefore not qualify for the favorable dividend rates upon their ultimate distribution from the accounts.

VII. Foreign Corporations: In order for dividends from a foreign corporation to qualify for the reduced tax rates of the 2003 Act, the foreign corporation must be (i) incorporated in a possession of the U.S.; (ii) traded on an established U.S. securities market; or (iii) incorporated in a country that has entered into a comprehensive tax treaty with the U.S. Additionally, the reduced rates will not apply to dividends received from passive foreign investment companies (PFICs), foreign personal holding companies (FPHCs), or foreign investment companies (FICs).

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