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As noted in Part I of this series, unless Congress intervenes, 2012 will see the expiration of favorable tax treatment for "qualified" dividends, whereby such dividends are taxed at capital gains rates, instead of at ordinary income rates. Dividends are qualified, subject to a holding period requirement, if they are paid out of earnings from a U.S. corporation or a qualified foreign corporation. Foreign corporations are qualified if they are incorporated in a country which has a tax treaty with the U.S. and / or are readily tradable on established U.S. exchanges. Most firms trading as American Depository Receipts (ADRs) on U.S. exchanges are thus qualified. Note that dividends from Real Estate Investment Trusts (REITs) and Business Development Companies (BDCs) are usually not qualified. As far as these tests are concerned, an investor can usually rely on the designation of qualified vs. not qualified as specified on the Forms 1099-DIV received from brokerages or from the payers directly. As will be explained in a moment, dividends that nominally are qualified, as per the 1099-DIV reporting, are not qualified if a holding period requirement is not met. Further, the holding period can be affected if the investor enters into an offsetting position as a hedge to the long stock position.

Understanding Form 1099-DIV

The data as reported on Form 1099-DIV is organized as follows:

  • Box 1a - Total Dividends. Mutual funds also report an investor's share of ordinary dividends received by the fund on Form 1099-DIV in Box 1a. Short-term capital gains distributions, which are taxed as ordinary income, are also included in Box 1a, if applicable. If the total dividends from all sources exceeds $1,500, Schedule B is required to be filed with the tax return.
  • Box 1b - Qualified Dividends, as determined by the preparer. As noted, a taxpayer may cause otherwise qualified dividends to not be qualified if a holding period requirement is not met.
  • Box 2a - Capital Gains Distributions. Shows long-term capital gains distributions received from a fund or REIT. Note that any value shown here qualifies as long-term capital gain regardless of how long the taxpayer owned the mutual fund or REIT shares. These are reported directly on line 13 of Form 1040 if Schedule D is not required, or on line 13 of Schedule D.
  • Box 2b - Shows the portion of Box 2a amount, if any, that is from Unrecaptured Section 1250 Gain from the sale of depreciable real estate. This can occur for holders of REIT shares. This value is only used with the Unrecaptured Section 1250 Gain Worksheet in the Schedule D instructions, to determine the value for line 19 of Schedule D.
  • Box 2c - Shows the portion of Box 2a amount, if any, that is from small business stock eligible for a 50% or 60% exclusion, as Section 1202 Gain. Very few investors will see a value here.
  • Box 2d - Shows the portion of Box 2a amount, if any, that is subject to a 28% Rate Gain on sale of collectibles. This value is only used with the 28% Rate Gain Worksheet in the Schedule D instructions, to determine the value for line 18 of Schedule D. Investors may be surprised to learn that the popular commodity ETFs GLD and SLV are considered to be collectibles by the IRS. A holder of these ETFs is unlikely to have any gains reported on 1099-DIV from small incremental sales by the ETF, but will be affected if shares are sold, which will be reported on 1099-B.

Note: If any values are shown in Box 2b, 2c, or 2d, Schedule D must be filed.

  • Box 3 - Nontaxable Distributions. Any value shown here is a return of capital, and is not reported as income. One way that this could occur would be if a payer was not profitable, but still paid out dividends to shareholders. Although not counted as income, any payouts received that are a return of capital must then reduce the investor's cost basis in the stock making such payments. If a holder's basis has been reduced to zero by such payments, any further return of capital distributions are reported as capital gains on Schedule D.
  • Box 4 - Withholding at a 28% rate which was applied because the taxpayer has not supplied the payer with a Tax Identification Number (NYSE:TIN).
  • Box 5 - A fund holder's share of expenses deductible as a miscellaneous itemized deduction, the total of which is subject to a 2% floor. Only applicable to non-publicly offered mutual funds.
  • Boxes 6 & 7 - Foreign Tax Paid, and Identified Country. This value may be used as a tax credit on line 47 of Form 1040. Form 1116 used to be required in all cases to claim the credit, but effective with 2011, it is not required if a list of conditions detailed in the 1040 instructions are met.
  • Boxes 8 & 9 - Cash and Non-Cash Liquidation Distributions. Only applicable for corporations in liquidation. Usually treated the same as a return of capital distribution.

A taxpayer may receive dividends, both qualified and non-qualified, that are not reported on a Form 1099-DIV. An example would be an investor owning units in a Master Limited Partnership (NYSE:MLP). Note that the payments actually received by the MLP unit holder, termed distributions, are not reportable as dividends, but are reported as part of an involved process whereby information shown on the Form K-1 received from the partnership is folded into various schedules in the investor's overall tax return. Among many other items shown on the K-1 will be the unit holder's share of any portfolio income from dividends received by the partnership during the year, on lines 6a and 6b of the K-1. These are reportable as dividends, just as are dividends reported on Forms 1099-DIV. Processing of K-1s received from MLPs is beyond the scope of this series of articles. There is a wealth of information available on the topic from the partnerships themselves. Each year, detailed instructions for handling the K-1s generated by a given partnership are made available to the partnership's unit holders.

Another quirk, which should be handled properly by the 1099-DIV preparer, is that mutual fund or other regulated investment company dividends or REIT dividends actually paid after year-end are reportable in the tax year declared, if such declaration occurred in the fourth quarter of the tax year. Some Business Development Companies (BDCs) may be classified as regulated investment companies. This could cause confusion for investors dutifully tracking dividend payments in detail.

Holding Period Requirement for Qualified Dividends, Impact of Offsetting Position on Holding Period

Failing the holding period requirement can cause otherwise qualified dividends to become non-qualified. The requirement is that the stock must have been held for at least 61 days during the 121 day period commencing 60 days prior to the ex-dividend date, and ending 121 days later. The day after the purchase trade date marks the start of the holding period, and if the stock was sold, the day the shares were sold, the sale trade date, counts as the final day of the holding period. Note that preferred stock dividends may not be qualified if the preferred series is considered a debt instrument, rather than a stock. Further, some preferreds that are qualified may pay on a schedule other than quarterly, and thus the holding period parameters are different. For example, for preferreds paying dividends on an annual schedule, the holding period must be 91 days, during the 181 day period beginning 90 days before the ex-dividend date. Other than the caveat for preferreds paying annually, I have not seen anything in the literature indicating that the 121 day holding period requirement is different for common stocks paying monthly, semi-annually, or annually instead of quarterly.

The holding period does not have to be contiguous, but the total of days the stock was held long has to add up to 61 days (or 91 days if applicable).

Wait, it gets worse. Any days during the 121 day period (or 181 day period, if applicable) during which the long stock position was hedged do not count towards the holding period. This would come into play if a long put was purchased, or if a concurrent short position was entered into. The hedge rule applies even if the hedge position is in a totally different account, even an IRA. Note that an out-of-the-money (OTM) covered call mercifully does not count as a qualified dividend holding period hedge disqualifier. But to avoid this, one must be careful that any covered calls written are qualified, which in this case means qualified as being exempt from the tax straddle rules. See article VI in this series for an in-depth discussion of the tax straddle rules and qualified covered calls. If the presence of a hedge position causes the long stock holding period test to be failed, the dividends received are not qualified.

Another quirk relates to both a long and a short position held on the same stock, such that the investor, as a short seller, is required to make a restitution payment in lieu of the dividend on the borrowed shares which were sold short. Even if the short position was held for only a brief time, and did not cause the long stock holding period test to be failed, the investor still cannot claim the dividends received on the long position as qualified if payment in lieu of dividends in the same amount had to be made on the same stock because of a concurrent short position.

How to Realize the Benefit of Qualified Dividends

After determining all dividends which are really qualified, the next step is to be sure and handle things properly, to receive the tax benefit. This can only be done by computing tax liability using the Qualified Dividends and Capital Gain Tax Worksheet in the Form 1040 instructions or, if applicable, by using the Schedule D Tax Worksheet. The Schedule D Tax Worksheet will be required if the taxpayer is required to file Schedule D and either or both of line 18 and line 19 on Schedule D are not zero. This can only occur if the taxpayer has values on these lines after completing the 28% Rate Gain Worksheet and the Unrecaptured Section 1250 Gain Worksheet, respectively, in the Schedule D instructions.

Payments In Lieu of Dividends from Short Sellers

This can only occur in a margin account. Brokerages frequently specify in the Hypothecation Agreement an investor agrees to when the margin account is opened that the brokerage can loan out shares held in the account to short sellers. If your long shares are loaned out, you will receive a payment "in lieu" of the dividend, which is actually paid by the short seller. These payments, even if emanating from a long position in a stock that would be otherwise qualified, are not eligible for qualified dividend treatment. In fact, they are not dividends at all. They are supposed to be reported as miscellaneous income on Form 1099-MISC, Box 8, and reported on line 21, Other Income, on Form 1040. Holders who do not want their shares to be loaned out can try to have a Loan Exempt Restriction placed on their account. While this probably will be accommodated by mainstream retail brokerages, firms catering to traders may not be as receptive to such a request. I have not personally tried to take this step, but I would consider it if I had a lot of otherwise qualified dividends being paid "in lieu".

Resources and Disclaimer

All of the preceding is based on my review of the following resources:

J.K. Lasser's Your Income Tax for 2013, available from bookstores everywhere.

Taxes and Investing Brochure from the Options Clearing Corporation (NYSE:OIC), available as a PDF file online here.

Various IRS Publication, particularly the 1040 instruction booklet, along with instructions for Schedules A, B, C, D, and E, and Publication 550, Investment Income and Expenses. A link to the IRS website is provided here.

While I have made a good faith effort to understand and present the topics discussed in this article, relying upon the resources cited, I want to reiterate that I am not a financial professional, nor am I certified in any way as a financial advisor or tax expert. I am an independent, individual investor, focusing on dividend-paying stocks exclusively. I am always seeking to become more knowledgeable on investments and related topics, and on sharing what I have learned with other investors in similar circumstances. Also, I want to reiterate a caution mentioned in the first paragraph of Part I, which is that the points I am bringing out are limited to commonly occurring situations that investors in publicly traded stocks and options experience, with positions held "in street name" in brokerage accounts. Readers need to realize that the information as presented is not all-inclusive, and that there are many exception conditions and special cases that are not being discussed.

Investors are advised to seek professional tax advice and assistance in handling their own tax situation. However, becoming a knowledgeable and conversant client on tax issues affecting investors will save time and money, and will improve the likelihood of correct tax filings.

Next up is Part III - Capital Gains and Losses - Basics.

Source: Stocks, Options, Taxes: Part II - Dividends