by Bob Rywick

The Jobs and Growth Tax Relief Reconciliation Act of 2003 provides that the qualified dividends of non-corporate taxpayers received in a taxable year beginning after Dec. 31, 2002, will be treated as part of adjusted net capital gain. As a result, those dividends will be taxed at a maximum rate of 15 percent (5 percent if the taxpayer is otherwise in a tax bracket under 25 percent).

As originally enacted, the act also provided that dividends of fiscal year regulated investment companies and real estate investment trusts received after 2002 in a taxable year beginning in 2002 would be treated as qualified dividends. Thus, if those dividends were distributed to a non-corporate taxpayer, such as an individual, estate or trust, in a taxable year of the non-corporate taxpayer beginning in 2003, they would be taxed as qualified dividends.

There was no similar provision, however, for other fiscal year pass-through entities, such as estates, S corporations, partnerships and common trust funds. Thus, if such an entity received a dividend in 2003 in a fiscal year that began in 2002, and the dividend was distributed or passed through to a beneficiary, shareholder or partner, the dividend would not be treated as a qualified dividend. This was so even if the dividend was taken into account by the beneficiary, etc., in a taxable year that began in 2003.

Technical correction bills introduced in the House (H.R. 3654) and the Senate (S. 1984) would provide that the rule that applies for fiscal year RICs and REITs would also apply to these other pass-through entities. While the technical corrections are to be retroactively effective so that they would apply as if originally included in the Jobs and Growth Act, Congress has not yet passed either bill.

As a result, tax return preparers didn’t know whether to rely on the proposed technical corrections in preparing 2003 tax returns. If they didn’t rely on them, and the technical corrections were later passed (as they almost certainly will be), they would have to file amended returns for taxpayers who would benefit, since some dividends would now meet the definition of qualified dividends. (For more on the technical corrections, see Jones & Luscombe, page 10).

The Internal Revenue Service now says (in Announcement 2004-11) that taxpayers may rely on the technical corrections in preparing their 2003 federal income tax returns, even though they have not yet been passed by Congress. Accordingly, fiscal year partnerships, S corporations, estates (and revocable trusts treated as part of a fiscal year estate) and common trust funds may pass through dividends received in 2003 to their partners, shareholders and beneficiaries as qualified dividends taxed at the lower rates.

Example 1: Your client, a calendar year taxpayer, is a 20 percent partner in a fiscal year partnership with a taxable year that ends on June 30. The partnership owns 10,000 shares of stock in CGR Corp., which pays a quarterly dividend of $1.00 a share. In its fiscal year ending June 30, 2003, the partnership received dividends in the total amount of $40,000 from CGR, $20,000 of which was received in 2002, with the balance of $20,000 received in 2003.

Your client’s share of the total dividends is $8,000. Of this amount, $4,000 is taxable on his federal 2003 individual income tax return as ordinary income and the other $4,000 is taxable as qualified dividend income taxable at a maximum rate of 15 percent.

Fiscal year estates (but not fiscal year individuals) may have qualified dividends in a taxable year beginning in 2002 if the dividends are received in 2003. The Jobs and Growth Act originally provided that qualified dividends were treated as part of the adjusted net capital gain of non-corporate taxpayers only in taxable years beginning after 2002. The proposed technical corrections now implemented by the IRS in Announcement 2004-11 provide that this rule doesn’t apply to pass-through entities.

Instead, qualified dividends received in 2003 in a taxable year beginning in 2002 will be treated as part of adjusted net capital gain. As a practical matter, however, the proposed technical correction only affects estates. Partnerships, S corporations and common trust funds are not taxable on dividends that they receive, trusts must have a calendar year as their taxable year, and RICs and REITs are not non-corporate taxpayers.

On the other hand, an estate is a non-corporate taxpayer, and may have a fiscal year as its taxable year. Thus, an estate that receives a dividend after 2002 in a taxable year beginning in 2002 may treat that dividend as a qualified dividend if the other requirements for qualified dividend status are met. If the dividend is not distributed to the estate’s beneficiaries, it will be taxed at a maximum rate of 15 percent to the estate.

Example 2: Your client, the executor of her brother’s estate, chose a fiscal year beginning Oct. 1, 2002, and ending Sept. 30, 2003, as the estate’s first taxable year. The estate owns an interest in a partnership with a fiscal year that begins July 1 and ends June 30. The partnership passes through dividends to the estate in the amount of $10,000, received by the partnership in 2003 in its taxable year beginning July 1, 2002. The dividends otherwise meet the tests for qualified dividends. The estate does not distribute the dividends to its beneficiaries in its taxable year ending Sept. 30, 2003. The dividends are treated as part of the estate’s adjusted net capital gain and are taxed at a maximum rate of 15 percent, even though they were received in a taxable year beginning before 2003.

Unlike an estate, a fiscal year individual may not treat dividends received in a taxable year beginning before 2003 as qualified dividends even if thay are received in 2003 or passed through or distributed by a pass-through entity in 2003.

Example 3: The same facts apply as in Example 2, except that your client is an individual with a taxable year beginning Oct. 1 and ending Sept. 30. The dividends received by the partnership in 2003 that are passed through to your client in her taxable year beginning Oct. 1, 2002, and ending Sept. 30, 2003, are not qualified dividends and are not treated as part of her adjusted net capital gain for that taxable year.

The IRS also says that it will apply changes in the holding period rules contained in the technical correction bills as though the bills had been passed. Under the rules as originally enacted, a taxpayer who acquired stock the day before the ex-dividend date for a particular dividend could not treat that dividend as a qualified dividend.

That’s because, under those rules, if a shareholder didn’t hold a share of stock for more than 60 days (i.e., at least 61 days) during the 120-day period beginning 60 days before the ex-dividend date, dividends received on the stock with respect to that ex-dividend date couldn’t be considered as qualified dividend income.

In determining the number of days that stock is held, the date of purchase is not counted but the date of sale is. Thus, if stock was bought on the day before the ex-dividend date, its holding period would begin on the ex-dividend date and the stock could not be held for more than 60 days in the applicable 120-day period.

The technical correction bills would change the 120-day period to a 121-day period beginning at the same time. As a result, stock bought the day before the ex-dividend date could be held for 61 days during the 121-day period.

Example 4: Your client bought stock in CRG Corp. on Aug. 1, 2003, the day before the stock went ex-dividend. She held the stock for the balance of the year. Nevertheless, if the proposed technical correction was not applied, your client held the stock for only 60 days (and not the required 61 days) during the 120-day period. The period began on June 3, 2003 (the date 60 days before the ex-dividend date of Aug. 2, 2003), and ended on Sept. 30, 2003. She held the stock for 30 days in August (from Aug. 2 through Aug. 31) and for 30 days in September (from Sept. 1 through Sept. 30).

However, with the IRS applying the 121-day period of the proposed technical correction, your client held the stock for 61 days during this 121-day period, since the period ended on Oct. 1, 2003.

Observation: The ex-dividend date is the first date following the declaration of a dividend on which the purchaser of a stock is not entitled to receive the next dividend payment.

A similar holding period exists for preferred stock dividends attributable to a period exceeding 366 days. Under the now-implemented technical correction, this holding period is at least 91 days during a 181-day (instead of 180-day) period beginning 90 days before the ex-dividend date.


Bob Rywick is an executive editor at RIA, in New York, and an estate planning attorney.

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