4.2 Qualified Corporate Dividends Taxed at Favorable Capital Gain Rates
Dividends paid out of current or accumulated earnings of a corporation are taxable (4.5). Stock dividends on common stock (4.6) are generally not taxable, but other types of stock dividends are taxed (4.8).
Dividends from most domestic corporations and many foreign corporations received in 2012 are treated as “qualified dividends,” which are subject to the same favorable rates as net capital gain (the excess of net long-term capital gains over net short-term losses (5.3)); see the Caution on this page concerning years after 2012. The rate for 2012 is either 15% or zero, depending on the rate that would otherwise apply to the dividends. The benefit of the zero or 15% reduced rate is obtained as part of the computation of tax liability on the “Qualified Dividends and Capital Gain Tax Worksheet” in the 2012 instructions for Form 1040 or Form 1040A, or, if required, on the Schedule D Tax Worksheet (5.3). On the Qualified Dividends and Capital Gain Tax Worksheet (or Schedule D Tax Worksheet, if applicable), the 15% rate is applied to qualified dividends and net capital gain that does not escape tax under the zero rate.
Filing Tip
Generally, the zero rate applies to taxpayers whose top bracket is 10% or 15%. Such taxpayers are not taxed at all on their qualified dividends and net capital gain. However, the zero rate is generally not available for qualified dividends (or net capital gain) earned by children and students under age 24 who are subject to the “kiddie tax” rules (24.2); their dividends and gains are taxed as if earned by their parents, who likely are subject to the 15% (rather than zero) rate on dividends/gains. Although the zero rate is intended to benefit taxpayers with modest incomes, taxpayers with substantial dividends/gains whose top bracket would be 25% or higher if there were no capital gain rates may pay no tax (zero rate) on a portion of their qualified dividends/net capital gains, provided their ordinary income (such as salary and interest) is low.
Caution
On Form 1099-DIV for 2012, the amount of qualified dividends eligible for the zero or 15% rate will be shown in Box 1b. To be eligible, the dividend must be received on stock you held at least 61 days during the 121-day period beginning 60 days before the ex-dividend date. The ex-dividend date is the first date following the declaration of a dividend on which the purchaser of the stock is not entitled to receive the dividend (4.9). When counting the number of days you held the stock, include the day you disposed of the stock but not the day you acquired it. You cannot count towards the 61-day test any days on which your position in the securities was hedged, thereby diminishing your risk of loss.
Some dividends from a mutual fund or exchange-traded fund (ETF) may be reported as qualified distributions on Form 1099 although they are not actually qualified distributions and cannot be reported as such on your return. Both you and the fund must hold the underlying security for the required 61-day period. The fund may report a dividend as qualifying without taking into account whether you purchased or sold your shares during the year, so you must determine whether you have met the 61-day holding period test for the shares on which the dividends were paid. When counting the number of days you held the shares, include the day you disposed of the shares but not the day you acquired them.
Generally, distributions on preferred stock instruments do not qualify for qualified dividend treatment because the instruments are hybrid securities that are treated as debt and not stock. Payments on such hybrid instruments are considered interest rather than dividends and thus are not eligible for the reduced tax rate. If the preferred instrument is treated as stock, the reduced rate does not apply to dividends attributable to periods totaling less than 367 days unless the 61-day holding period (discussed above) is met. If the dividends are attributable to periods of more than 366 days, the stock must be held at least 91 days in the 181-day period starting 90 days before the ex-dividend date.
Some dividends are actually interest. Distributions that are called dividends but are actually interest income, such as payments from credit unions and mutual savings banks, are not eligible for the reduced dividend rate. Similarly, certain dividends from exchange-traded funds (ETFs) and from mutual funds represent interest earnings and are not eligible for the reduced rate. Dividends paid by a real estate investment trust (REIT) generally are not eligible, but the reduced rate does apply to REIT distributions that are attributable to corporate tax at the REIT level or which represent qualified dividends received by the REIT and passed through to shareholders.
Dividends from foreign corporations qualify for the reduced rate if the corporation is traded on an established U.S. securities market, incorporated in a U.S. possession, or certain treaty requirements are met.
If your broker loans out your shares as part of a short sale, substitute payments in lieu of dividends may be received on your behalf while the short sale is open. Such substitute payments are not considered dividends and should be included in Box 8 of Form 1099-MISC and reported by you as “Other income” on Line 21 of Form 1040.
Tax-deferred retirement accounts such as traditional IRAs and 401(k) plans do not benefit from the reduced dividend rate. Distributions from such retirement plans are taxable as ordinary income even if the distribution is attributable to dividends.