Tax on Dividends – 6 Must-Know Facts

While not a primary concern for most investors, the tax on dividends may come into play at a late stage in the investment selection process when investors have to make a final choice among equities with similar performance outlooks.

Investors generally will look at easily accessible metrics, such as dividend yields, dividend payout ratios, history and level of annual dividend hikes and other financial indicators, to identify a small group of equities that meet their portfolio’s investment strategy. Once the investors identify this small group of equities that meet the high level criteria, investors conduct a more detailed analysis that should include consideration of the tax on dividends before making the final selection of securities in which to invest.

While taxation is a broad subject and requires extensive study to fully understand, below are six basic facts about the taxation of dividends that every investor should know to enhance the long-term returns of their investment portfolio.

Tax on Dividends – Fact #1

Tax rates on dividend distributions depends on dividend type.

Because of their simplicity and straightforward delivery method, cash dividends are the most common type of dividend distributions. Most investors – especially those who are new to income investing – are most familiar with this type of dividend distributions. However, equities also may distribute their assets to stakeholders as in-kind distributions.

Stock dividends are probably the most well-known type of in-kind dividends. However, stock dividends do not figure prominently into the taxation issue, since this type of dividend distribution does not carry any immediate tax liability. The Internal Revenue Service (IRS) treats stock dividends as stock splits. Therefore, no tax is due on stock dividends in the tax year in which investors receive the stock dividend distribution. Like with any other stock, investors are liable for taxes upon the sale of shares. Naturally, any profits from the sale of the shares are subject to taxation at capital gains rates for the year in which the shares are sold.

In addition to stock dividends, in-kind dividends include property dividends, promissory notes, accounts receivables, bonds of the company distributing dividends, bonds of a different corporation, government bonds, etc. In-kind dividends are not eligible for taxation at capital gains rates and are always taxed as ordinary income.

Tax on Dividends – Fact #2

Tax rates depend on dividend classification.

While cash dividends can be taxed at rates lower than ordinary income, only a portion of cash dividend distributions is eligible for the qualified status designation. Depending on the type of equity that distributes the dividends and the source of dividend distributions, the Internal Revenue Service (IRS) recognizes two types of dividend distributions for taxation purposes – Ordinary Dividends and qualified dividends. Ordinary dividends are subject to taxation at the same rates as all other ordinary income. Alternatively, qualified dividends have the benefit of incurring tax liability at capital gains rates – which are generally lower than ordinary income tax rates.

However, U.S. companies paying dividends must meet an extensive list of strict Internal Revenue Service (IRS) requirements to gain the qualified dividends status. Some foreign entities can qualify for the beneficial status under some circumstances. The foreign corporation must be incorporated in a U.S. possession, as well be eligible for the benefits of a comprehensive income tax treaty with the United States that the Department of the Treasury determines is satisfactory for this purpose. Additionally, foreign stocks that do not meet these first two requirements still could be eligible for qualified status if their stock is readily tradable on one of the established National Security Exchanges in the United States. However, these securities exchange markets must be registered under Section 6 of the Securities Exchange Act of 1934 or on the Nasdaq Stock Market.

Nevertheless, dividend distributions that meet all the above requirements can still be taxed as ordinary income if they fall into one of the categories on the IRS list of payouts that are not qualified dividends. In addition to the requirements above that the equity distributing the dividends must meet, investors also must meet a minimum holding period requirement to pay taxes at capital gains tax rates.

Tax on Dividends – Fact #3

Not all payouts are considered dividends for taxation purposes

As already seen with the stock dividends example above, not all dividends are treated as dividends by the IRS for tax consideration. For example, dividend distributions from master limited partnerships (MLPs), real estate investment trusts (REITs) and other tax-exempt entities are always taxed as ordinary income.

Furthermore, only regular dividend distributions are eligible for the reduced tax rates. One-time dividends, special dividends and dividends on employee stock options always incur tax liability as ordinary income. Payouts from money market accounts are technically interest distributions and must be reported by investors as interest income, which also is subject to taxation at ordinary income rates. Additionally, all dividend distributions associated with hedging – such as short sales, call options, put options, etc. – are ineligible for qualified dividend status and are taxed at the higher ordinary income tax rates.

Tax on Dividends – Fact #4

Dividends are taxed twice

Dividends are taxed at the corporate level, before considering individual investor tax implications. A corporation must pay income taxes on any of its profits before distributing a portion of its earnings as dividends. However, once the company distributes dividends to its shareholders, those dividend distributions are taxed again as individual income capital gains at the investor level.

The Tax Cuts and Jobs Act (TCJA) passed by Congress on December 22, 2017, reduced the corporate income tax rate from 35% to the current 21% level. However, the double taxation issue still remains. While many investors seek dividends as a steady income source, many corporations choose to focus on increasing capital gains through share buybacks, capital investments, debt repayments, business acquisitions, etc. to avoid double taxation of dividends.

Tax on Dividends – Fact #5

Dividends can be taxed three times

Triple taxation occurs when a corporation receives dividend distributions from another company in which it has ownership stake. After the original company already paid taxes on its profits, the corporation now has to pay taxes again on its share of dividend distributions. The third level of taxation occurs when the second corporation distributes dividends to its shareholders, which are taxed again at the individual investor level.

However, the current United States Code has allowances for corporations to deduct some or all of the received dividend distributions from their taxable income if they meet minimum ownership share in the company that distributed the dividends. Title 26, Subtitle A, Chapter 1, Subchapter B, Part VIII, Section 243 of the US Code contains the specific details and requirements that corporations must fulfill to meet eligibility for this type of deduction

Tax on Dividends – Fact #6

Investors can legally defer taxes on dividends until retirement.

Because most people pay higher marginal taxes while earning income during their working career, it is beneficial to defer any taxes on retirement funds until the actual retirement. The best way to accomplish this legally is to invest in dividend-paying equities through Individual Retirement Accounts (IRAs) – Traditional IRAs, Roth IRAs or Simplified Employee Pension plans (SEP IRAs).

Additionally, investing in dividend-paying equities through IRAs can result in taxation at levels below ordinary income rates even for some equities whose distributions do not meet the requirements for taxation at capital gains as qualified dividends.

Most investors generally will disregard tax implications in the securities selection process and focus on equities with the highest total return rates and favorable long-term projections. However, taking advantage of favorable tax treatments among similarly performing securities can provide small incremental returns that will compound into large total return advantages over extended time horizons.

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