IT'S THIS YEAR'S big tax conundrum.
When is a dividend a dividend?
Such a distinction didn't matter much until last year's tax cut.
"We had such a long period in which dividends were taxed at regular [income tax] rates that the term `dividend' became used rather loosely. It was applied to a lot of things that the IRS didn't truly consider a dividend," said Mark Luscombe, a principal at CCH Inc., a tax information provider in Illinois. "It didn't matter because it was all taxed the same way."
Last May, the tax rate on dividend income was cut retroactive to January 2003. Instead of being taxed as regular income, which then was at a rate of up to 38.6 percent, dividends are now taxed at 15 percent for most investors. Those in the lowest tax brackets - 10 percent and 15 percent - pay a rate of 5 percent.
Now, it's important to separate dividends that qualify for the tax cut from all the other types of investment income that have been labeled dividends but will remain taxed as regular income.
It's complicated, but taxpayers will be relieved to know that the burden of separating qualified dividends from all the rest falls on the shoulders of investment companies. The companies supply the dividend information to investors in 1099 tax forms that are supposed to be sent out by the end of January.
Taxpayers are already being warned this year to expect more corrected 1099s coming in the mail than usual. Some experts suggest waiting to file tax returns until revised 1099s come in, so taxpayers won't have to go through the time or expense of amending returns.
Generally, it's a safe bet that dividends from U.S. common stocks will qualify for the lower tax treatment.
What dividends aren't the real deal in the eyes of the Internal Revenue Service?
Dividends from real estate investment trusts, or REITs, typically don't qualify for the reduced tax rate.
Income from bond funds and money market funds are often labeled dividends but are actually interest. Some high-yield bond funds, however, own common stocks that pay dividends, and those dividends would qualify for the lower rate when passed on to shareholders, said Sam Beardsley, vice president of investment taxation at T. Rowe Price Associates in Baltimore.
Income from many preferred stocks is actually interest rather than dividends.
Dividends on foreign stocks might be eligible if they pass a hurdle. The stock, for example, must be traded on a U.S. exchange, or the company must be incorporated in a U.S. territory, Luscombe said. Another way to qualify is if the company comes under certain U.S. tax treaties.
Even if an investor receives a bona fide dividend, a holding period must be met. The formula is complicated, but essentially investors must hold a stock or mutual fund for least 61 days for the dividend to qualify for the lower tax. For preferred stocks with qualifying dividends, the holding period is 91 days.
The holding requirement is to prevent investors from buying and selling stocks to scoop up dividends and get the lower tax rate, said Bob Rywick, a senior analyst with RIA, a New York tax information provider.
It's up to taxpayers to make sure that they meet the holding requirements. For buy-and-hold investors, this shouldn't be a problem, Beardsley said.
The complicated work of deciphering dividends is left to brokerages and mutual fund companies, which had a Jan. 31 deadline to meet for sending out 1099s.
Expecting difficulties, the Securities Industry Association, which represents brokerages, asked in December for an extra month to send out the forms to reduce the number of corrections later.
In rejecting the request, the IRS said many taxpayers count on filing early to get a refund and moving the deadline would leave tax preparers less time to do their job.
In a typical year, 5 percent to 8 percent of 1099 forms are amended by brokerages, but this year "early indications are there will be a lot more corrections," said Patricia McClanahan, SIA's director of tax policy. Already, brokerages are reporting the number of amended 1099s they receive from mutual fund companies are about four times more than usual, she said.
Anticipated 1099 revisions are affecting tax preparers.
"We routinely get corrected 1099s after Jan. 31," said Anna Fink, a certified public accountant with Ellis & Associates in Baltimore. "This year it's far worse. I already got the first round of amended 1099s ... and we expect it to be more."
Fink is preparing clients' returns now, but recommending that those with lots of dividends wait until April 1 to file unless they have a huge refund coming and want the money earlier. Waiting lessens the chance of having to amend a return later because of corrections to 1099s.
Luscombe also advises that investors might reconsider allowing their brokerage to borrow their shares. Customer agreements many times give brokerages permission to borrow shares from one client to loan to another.
If the shares generate a dividend while out on loan, the brokerage makes it up to the owners by paying them an amount equal to the dividend. This so-called "payment in lieu of dividends" isn't a qualified dividend under the new tax law, meaning investors will pay more in taxes on that money, Luscombe said.
Brokerages are aware of the problem and trying to make sure these investors don't lose out on the tax cut, McClanahan said. Some, for instance, plan to pay investors more money to cover any extra taxes they owe. Other brokerages plan not to borrow shares when dividends are being paid out, she said.
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