Not All Dividends Qualify for the Reduced Tax Rate

Jobs and Growth Tax Relief Reconciliation Act of 2003 has reduced the dividend and long-term capital gain tax rates to as low as 15%(5%). However, in many instances the dividend is actually taxed at a maximum rate of 35% or not subject to tax at all. This paper investigates the requirements for applying different dividend tax rates. To be qualified for the 15% rate, dividend must be distributed from a corporation's earnings and profit. Pass-through dividends received by entities, such as mutual funds, regulated investment company, partnership, S corporation, etc., are also qualified for the reduced rate. Interest income continues to be taxed as an ordinary income item up to 35%. Many interest payments are described as a dividend, such as those from credit union and preferred stock. These distributions are not qualified for dividend treatment at a reduced rate. Distributions from real estate investment trust are not qualified for reduced dividend tax rates either, because the entity is not subject to income tax. For the reduced dividend tax rate to apply, a shareholder must own the stock for at least 60 days in a 120-day period surrounding the ex-dividend date beginning 60 days before the ex-dividend date. If a shareholder holds the stock for less than 61 days in this 121-day period surrounding the ex-dividend date beginning 61 days before the ex-dividend date, the dividend is taxed at the ordinary income tax rate up to 35%. If an investor borrows fund to purchase stock, there are two options. If the investor chooses to apply the reduced tax rate of 15% to the dividend and long-term capital gain, the dividend income or long-term capital gain cannot be included in computing the deductible interest expense. It means no interest expense is deductible, unless there are other sources of investment income, such as capital gain and interest income. If the investor chooses to deduct the interest expense, the dividend or long-term capital gain must be taxed as an ordinary income up to 35%. This paper shows the determination of a break-even point in making an optimal choice between these two options. As a guide, it also illustrates the gain or loss for the option of deducting the interest expense as compared with the option of no deduction. This paper further points out that an investor may also have an option to elect for a portion of the dividend income to be taxed at a regular rate up to 35% to the extent of interest deduction, and the remainder at a reduced rate of 15%. This strategy will yield the least tax liability. This paper also investigates the situation where dividend can be tax-free on both corporate and individual levels. A payment on corporate earnings is not a prerequisite for issuing the low-tax dividend. A corporation may use accounting scheme or tax credit to reduce tax liability. As a result, a corporation may have earnings and pays no income tax, and yet it still can distribute dividend. If shareholder can find a way to avoid dividend tax, such as interest expense deduction on borrowed funds, it leads to no taxation at all on dividends. Because of the new tax law a investor is in such a position to control how dividends are taxed. This paper offers insights to the complexity of taxation on dividend and long-term capital gain for the purpose of financial planning.