by Bob Rywick

For tax years beginning before 2003, a non-corporate taxpayer’s dividend income was taxed as ordinary income. In tax years beginning after 2002 and before 2009, the Jobs and Growth Tax Relief Reconciliation Act of 2003 treats the qualified dividend income of non-corporate taxpayers (individuals, estates and trusts) as part of adjusted net capital gain.

As a result, qualified dividend income is taxed at the same lower rates that apply to the taxation of adjusted net capital gain. Thus, they are taxed at a maximum rate of 15 percent (5 percent to the extent they would be taxed at a rate under 25 percent if they were treated as ordinary income).

These rates apply for alternative minimum tax purposes, as well as for regular income tax purposes. For tax years beginning in 2008 only, the 5 percent rate is reduced to 0 percent.

Adjusted net capital gain defined after the act. After the act, adjusted net capital gain is defined as net capital gain (without taking qualified dividends into account), reduced (but not below zero) by the sum of:

● 25 percent rate gain (i.e., unrecaptured Section 1250 gain); and,

● 28 percent rate gain (i.e., collectibles gain and gain on the unexcluded part of gain on the sale of Section 1202 small business stock); plus,

● Qualified dividend income.

For purposes of determining the maximum rate at which adjusted net capital gain is taxed, qualified dividend income received in 2003 is treated as received after May 5, 2003, regardless of when the dividend was actually received.

Thus, the transitional rule that taxes capital gains on sales before May 6, 2003, at the pre-act maximum rates of 20 percent, or 10 percent (8 percent on qualified five-year gain) for taxpayers in a tax bracket under 25 percent, doesn’t apply to qualified dividend income.

Example 1: Your client’s net capital gain for 2003 before taking qualified dividend income into account is $75,000. Of this amount, $15,000 represents un-recaptured Section 1250 gain on the sale of real property (i.e., gain attributable to depreciation taken on the property).

Your client has no 28 percent rate gain in 2003. Your client also has $25,000 of qualified dividend income. Your client’s total adjusted net capital gain for 2003 is $85,000 ($75,000 of net capital gain, less $15,000 of un-recaptured Section 1250 gain, plus $25,000 of qualified dividend income).

Observation: In Example 1, the $25,000 of qualified dividend income will be taxed at a maximum rate of 15 percent, since qualified dividend income received at any time in 2003 is treated as received after May 5, 2003. The maximum rate at which the remaining $60,000 of adjusted net capital gain will be taxed depends on whether a particular gain was received before May 6, 2003, or after May 5, 2003.

Observation: Net capital gain is the excess of net long-term capital gains over net short-term capital losses. Qualified dividend income is added to net capital gain to get adjusted net capital gain only after net capital gain is so determined, and is then reduced by the sum of 25 percent rate gain and 28 percent rate gain.

Also, net capital gain cannot be reduced below zero before adding qualified dividend income to net capital gain to get adjusted net capital gain. This means that adjusted net capital gain can never be less than the amount of qualified dividend income.

Example 2: Your client, a single taxpayer, has taxable income of $60,000 (ordinary taxable income) in 2003 before taking capital gains and losses and qualified dividend income into account. She also has a net capital loss of $20,000, and qualified dividend income of $25,000. Her adjusted net capital gain is $25,000, i.e., it equals the amount of qualified dividend income since she has no net capital gain. The net capital loss does not reduce the adjusted net capital gain that is attributable to the qualified dividend income.

Observation: If a non-corporate taxpayer has a net capital loss, $3,000 ($1,500 for married taxpayers who file separate returns) of that loss can be applied to reduce other income of the taxpayer.

In Example 2, it’s not completely clear whether that $3,000 should be used to reduce the $60,000 of taxable income other than the qualified dividend income, or whether it must be used to first reduce the qualified dividend income.

The better view seems to be that it should be used to reduce income taxed at the highest rate first. This would be consistent with how capital losses of one type are used to offset capital gain of another type.

For example, a net short-term capital loss is used to offset 28 percent rate gain before it is used to offset capital gain taxed at a lower rate.

Qualified dividend income defined. Qualified dividend income means dividends received during the tax year from domestic corporations and qualified foreign corporations. A qualified foreign corporation is:

● A corporation incorporated in a U.S. possession; or,

● A corporation that is eligible for the benefits of a comprehensive income tax treaty with the U.S. which the Internal Revenue Service determines is satisfactory for purposes of the qualified dividend income rules, and which includes an exchange of information program.

Congress intends for a corporation to be eligible for the benefits of a comprehensive income tax treaty for purposes of this rule if it would qualify for the benefits of the treaty with respect to substantially all of its income in the tax year in which the dividend is paid.

A corporation also will be treated as a qualified foreign corporation with respect to any dividend paid by that corporation, if the stock for which the dividend is paid is readily tradable on an established securities market in the U.S.

A share will be treated as so traded if an American Deposit-ory Receipt backed by the share is so traded. If some dividends are paid with respect to stock (e.g., common stock) traded on an established securities market in the U.S., and other dividends are paid on stock that is not so traded (e.g., a class of preferred stock), the other dividends will not be qualified dividend income.

To be treated as a qualified dividend, a distribution must first meet the Internal Revenue Code Section 316 definition of a dividend, i.e., it must be made out of current or accumulated earnings and profits.

Observation: Presumably, payments to shareholders that are treated as “constructive dividends” are eligible to be qualified dividend income. Constructive dividends may arise where the corporation makes payments on behalf of, or for the benefit of a shareholder, where the shareholder diverts corporate funds for his own use, or where the corporation pays a shareholder-officer “excessive” compensation.

Taxpayers who are both shareholders and employees of a corporation, and who receive corporate payments that are arguably either compensation or constructive dividends, will benefit if those payments are treated as lower-taxed qualified dividend income.

On the other hand, the corporation will not get a deduction if the payment is treated as a dividend instead of compensation. Depending on the corporation’s and the shareholder’s tax brackets, total taxes may be higher if the payment is treated as a constructive dividend even if it meets the definition of qualified dividend income.

Qualified dividend income does not include the following:

● Any dividend on any share of stock not held for more than 60 days during the 120-day period beginning 60 days before the ex-dividend date. In the case of certain preferred stock, a share must be held for more than 90 days during the 180-day period beginning 90 days before the ex-dividend date if the dividend is attributable to a period or periods aggregating more than 366 days.

● Any dividend on any share of stock to the extent that the taxpayer is under an obligation (whether pursuant to a short sale or otherwise) to make related payments with respect to positions in substantially similar or related property.

● Payments in lieu of dividends (e.g., dividends paid with respect to stock that a broker has loaned to a customer, where the dividends are paid to the short sale buyer before the short sale is closed).

● Any amount that the taxpayer elects to take into account as investment income under IRC Section 163(d)(4)(B). If this election is not made, the lower tax rate on qualified dividend income will apply, but the qualified dividend income will not be taken into account in determining the amount of investment interest expense that the taxpayer may deduct.

● Any dividend from a corporation if, in the tax year in which the distribution is made (or the preceding tax year), the corporation is exempt from tax as a charitable, etc. corporation under IRC Section 501, or as a farmers’ cooperative.

● Any amount allowed as a deduction for dividends paid by a mutual savings bank, etc. under IRC Section 591.

● Any applicable dividend paid on “applicable employer securities” held by an employee stock ownership plan.

Dividends from a regulated investment company. Recipients of dividends from a regulated investment company (e.g., a mutual fund) may treat those dividends as qualifying dividend income only to the extent that the RIC received dividend income that’s qualified dividend income.

However, if at least 95 percent of the RIC’s gross income consists of qualified dividend income, the entire dividend received by a non-corporate shareholder is treated as qualified dividend income.

Example 3: In 2003, a mutual fund has $9 million of qualified dividend income, $500,000 of long-term capital gain, $300,000 of short-term capital gain and $200,000 of taxable interest. The fund may distribute $9 million of qualified dividend income to its shareholders.

Example 4: The same facts apply as in Example 3, except that the fund has $9.5 million of qualified dividend income and no long-term capital gain. The entire amount distributed to its shareholders will be qualified dividend income.

Rules similar to the rules for RICs apply to real estate investment trusts.

Observation: Distributions from money market funds out of interest earned by the fund are not distributions of qualified dividend income even though they are reported to shareholders as dividends. Money market funds are a form of RIC.

Thus, distributions from a money market fund can be qualified dividend income only to the extent that the money market fund received qualified dividend income for the tax year.

It would be rare for a money market fund to receive qualified dividend income since most of its income consists of interest earned on short-term obligations.

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