by George G. Jones and Mark A. Luscombe

The 1040 tax forms for 2003 have now been published. The related instructions have now been finalized. Yet as taxpayers, and tax return preparers, compare their particular facts to the information provided, many issues remain unresolved.

Preferred stock holding period

If you read the provisions of the Jobs and Growth Tax Relief Reconciliation Act of 2003, you would properly conclude that, for qualified dividend treatment, both common and preferred stock must be held for more than 60 days in the 120- day period around the ex-dividend date.

The House bill originally had separate holding periods for common and preferred stock, but when the Conference Committee changed the holding period, it appeared to create a common period for both common and preferred stock.

Yet, the instructions for Line 9b in the Form 1040 instructions state that dividends attributable to a period totaling more than 366 days that you received on any share of preferred stock held for less than

91 days during the 180-day period that began 90 days before the ex-dividend date are not qualified dividends.

Where does that come from?

It comes from a provision in the Tax Technical Corrections bill (H.R. 3654) that has not yet passed Congress. Under Section (2)(A) of that bill, sub-clause (I) of Code Sec. 1(h)(11)(B)(iii) is amended by striking “section 246(c)(1)” and inserting “section 246(c).” That simple change brings into the law the longer holding period for preferred stock.

Even though Congress has not passed the bill, leadership has promised to do so retroactively.

Therefore, to not follow the corrections in filing 2003 returns could create the need for a lot of amended returns, which the Internal Revenue Service appears to be trying to avoid.

Remember that the preferred stock holding period issue only applies to preferred stock that is really preferred stock in the first place. Most of the preferred stock out there is paying a distribution that is treated as interest by the IRS because the issuing corporation is taking an interest deduction. Such hybrid preferred stock would not pay a qualified dividend regardless of the holding period.

Stock purchases the day before the ex-dividend date

If you thought that the IRS would routinely apply the technical corrections to avoid the need for amended returns, it does not appear to be doing so.

Although the IRS is following the technical corrections in the case of the preferred stock holding period, a position unfavorable to taxpayers, it appears from the 1040 instructions that it is not following the technical corrections with respect to whether dividends on stock purchased the day before the ex-dividend date are qualified dividends, also a position unfavorable to taxpayers.

Qualified dividends require a holding period of more than 60 days in the 120-day period around the ex-dividend date (ignoring the separate preferred stock holding period for the moment).

By custom, the date that a stock is purchased is not counted in the holding period, but the sale date is counted.

As a result of this, a stock purchased the day before the ex-dividend date could not meet the test for a qualified dividend, since the 120-day period would expire before the more-than-60- day requirement could be fulfilled.

This situation is illustrated in Example 2 in the Form 1040 instructions for Line 9b.

This has been recognized as an unintended result, and Section 2(2)(B) of the technical corrections bill changes the holding period range from 120 days to 121 days to solve this problem.

The majority and minority heads of the congressional tax writing committees have sent letter to the Treasury Department and the IRS asking that the IRS treat technical correctionsas having passed in order to avoid the burden of a large number of revised 1099s being issued and taxpayers being required to later file amended returns.

As of the time this articlegoes to press, the IRS has not indicated how it will respond to  the request.

Holding period for mutual funds

Code Sec. 852(b)(3)(b) provides that mutual fund shareholders may treat as long-term capital gain any sums reported as a capital gain dividend by a mutual fund. There is no such clear statutory protection making sums reported as qualified dividends by a mutual fund also qualified dividends in the hands of the fund holder.

In fact, Example 3 in the Form 1040 instructions for Line 9b makes clear that, in the IRS’s view, if the taxpayer owning the fund has not held the fund itself for more than 60 days, the taxpayer can receive no qualified dividends from that fund.

What the example does not make clear, however, is how the fund holder is to treat a dividend where the mutual fund holder has held the fund for more than 60 days, but not more than 60 days with respect to a particular ex-dividend date of a stock held by the fund.

What if a mutual fund holder bought into the fund the day before the ex-dividend date of a stock held by the fund and has not disposed of the fund after more than 60 days? The fund holder is certainly eligible to receive qualified dividends from the mutual fund, but perhaps not qualified dividends where the ex-dividend date was the date after the date that the fund was purchased.

Many fund holders do not know what stocks are held by the funds that they own, let alone the ex-dividend dates of those stocks. It is very unlikely that the IRS would expect that it could realistically impose such a burden on mutual fund holders.

This problem would also be solved by the technical corrections bill, but again it appears at this point that the IRS is not applying the particular technical correction in the 2003 instructions, although they may change their position in response to the congressional input stating that the technical corrections will pass with retroactive application and are consistent with what Congress had intended the law to be.

The letter from the congressional tax writers to the Treasury asserts that millions of mutual fund holders could be faced with amended 1099s after filing their tax returns unless the technical corrections are viewed as already passed.

Reliance on the 1099-DIV

Anticipating that 1099 issuers and recipients might have difficulty reflecting the capital gain and dividend changes in time for the 2003 filing season,

Congress in its committee reports for the 2003 tax act had encouraged the IRS to go easy on taxpayers for the 2003 filing season, allowing taxpayers to rely on what was reported on the 1099-DIV unless they know or have reason to know that it is not a qualified dividend.

The IRS has taken this suggestion to heart, but only expressly in a couple of specific areas: dividends from foreign corporations and payments in lieu of dividends (payments received on stock the taxpayer thinks is held in a street account with a broker, but which really has been borrowed by the broker to cover the short-selling transactions of other customers). With respect to other areas, the IRS has included, in the Form 1040 instructions for Line 9b, five instances in which a dividend reported as a qualified dividend on the 1099-DIV should not be treated as a qualified dividend by the taxpayer.

These five identified areas include common stock that has not met the required holding period and preferred stock that has not met the required holding period. Also included are payments in lieu of dividends, but only where the taxpayer knew or had reason to know that the payments were not qualified dividends.

The other two identified situations involve dividends that the taxpayer receives as a nominee and dividends with respect to a stock where the taxpayer was involved in offsetting positions, such as short sales or other forms of hedging transactions.

The IRS is clearly trying to identify situations in which the dividend is not qualified due to activities of the taxpayer or information that would be possessed by the taxpayer.

Yet, requiring taxpayers to report something different on their returns than is reflected on their 1099s leaves the IRS with a significant audit problem.

The IRS computers will probably accept the returns of taxpayers that simply put on their returns what is reflected on the 1099s. Only time-consuming and expensive audits will catch those who do not observe the exceptions.


The evidence is already mounting that many taxpayers are bewildered by the impact of the capital gains and dividend changes in the 2003 tax act.

With respect to capital gains, the problems arise primarily from the mid-year change in rates and trying to figure out what goes where on a more complicated Schedule D. For dividends, the problem is less evident on the forms — on the

Form 1040, Line 9 is simply divided into Line 9a for ordinary dividends and Line 9b for qualified dividends.

Taxpayers, however, are having a very difficult time figuring out what goes on which line.

Since taxpayers cannot always rely on what the 1099-DIV says, even tax software programs might not be too helpful in trying to sort out the distinctions.

The 2003 filing season may encourage even more taxpayers to seek out professional help to file their tax returns.

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