*Editor’s Note- Check out our blog, How do I know if my Dividends are Qualified or Ordinary? for the most recent information.

Every investor hopes for a strong return on investment from their stock portfolio, but the truth is that dividends paid out from corporate stocks are not created equal. The way in which dividends are treated for tax purposes plays a central role in an investor’s ROI, making it important for would-be and current investors to have a firm understanding of the different types of dividends and the tax implications of each.

There are two types of ordinary dividends: qualified and nonqualified. The most significant difference between the two is that nonqualified dividends are taxed at ordinary income rates, while qualified dividends receive more favorable tax treatment by being taxed at capital gains rates.

What classifies a dividend as ‘qualified’ for tax purposes?

Ordinary dividends are the most common type of distribution from a corporation or a mutual fund - as they are paid out of earnings and profits. Examples of ordinary dividends that do not qualify for preferential tax treatment include:

• Generally, dividends paid out by real estate investment trusts (there are instances where dividends can be considered qualified, provided certain requirements are met - - See IRC §857(c))
• Generally, dividends paid out by master limited partnerships (However, if the MLP is invested in qualifying corporations and it receives qualified dividends from those investments, it would pass out qualified dividends to the partners)
• Dividends paid on employee stock option plans
• Dividends paid by tax-exempt companies
• Dividends paid on savings or money market accounts by mutual savings banks, mutual insurance companies, credit unions and other loan associations

Other dividends paid out by U.S. corporations are qualified. In order to meet Internal Revenue Service standards, however, the requirements listed below must be met:

• The dividends must have been paid by a U.S. corporation or a qualified foreign corporation
• Investors must adhere to a minimum holding period

There are a few details to remember when considering these two rules. First, a foreign corporation is considered “qualified” if it has some association to the U.S., typically in the way of residing in a country that has a tax agreement in place with the IRS and Treasury Department. Because other circumstances may classify a foreign corporation as “qualified,” investors who are tax planning should consult a tax or accounting professional to determine definitively how dividends paid out by a foreign corporation will be classified for tax purposes.

Special holding rule requirements apply in order for a dividend to receive favorable tax treatment. For common stock, a share must be held more than 60 days during the 121-day period beginning 60 days before the ex-dividend date. Under IRS guidelines, the ex-dividend date is the date after the dividend has been paid and processed and any new buyers would be eligible for future dividends. For preferred stock, the holding period is more than 90 days during the 181-day period beginning 90 days before the stock’s ex-dividend date.

Will the election results impact dividends?

The 2017 Tax Cuts and Jobs Act didn’t change too much regarding taxes on dividends and capital gains. Under the TCJA, the 0% rate on dividends and capital gains no longer conforms exactly to the new standard tax brackets. But, basically, if you’re in the new 10% or 12% tax brackets, you’ll qualify for the 0% rate on dividends. Under the TCJA, people who qualify for the 15% rate will be somewhere in the 22% to 35% brackets for the rest of their income.

The recent election results could change this. Trump is proposing to lower the top long term capital gains tax rate to 15%. Biden’s plan proposes taxing net long-term gains at 39.6% for individuals with incomes above $1 million. Biden also would like long and short term capital gains taxes to be subject to the 3.8% net investment income tax.

For more information on how your dividends should treated for tax purposes please contact Dave Desmarais, CPA or any member of our Private Client Tax Services Group or call 888-KLR-8557.