Investment Income Tax Changes

What taxpayers need to know about dividends, interest and capital gains in the new tax landscape.

August 9, 2018
Blake Christian, Tax Partner and Justin Salley, Supervising Senior Tax Accountant

Key Takeaways

  • Regular dividends are generally not eligible for the lower long-term capital gains tax rates that Qualified Dividends receive unless the recipient holds the underlying shares for a specific period of time.
  • A common misconception is that the underlying shares must be held for longer than one year in order for any related dividends to be taxed as Qualified Dividends.
  • Since Real Estate Investment Trusts (REITs) generally pay no entity-level tax, dividends issued by a REIT are generally not eligible for the reduced rates assigned to Qualified Dividends.
  • Mutual fund distributions will only qualify for the reduced tax rate to the degree that the amount is determined to be a Qualified Dividend that’s received by the mutual fund.

Introduction
With the new 21 percent flat tax rate, along with liberalized asset depreciation and expensing provisions plus a lower tax on repatriated foreign earnings, the landmark Tax Cut and Jobs Act (TCJA) has been a boon to U.S. C corporations since its passage late last year. But, many individual taxpayers and their advisors are still digesting the changes and mulling over their next steps. Below is a primer about the tax treatment of dividends, interest and capital gains in light of the new tax reform landscape. 

Dividends vs. Qualified Dividends
According to Internal Revenue Code (IRC) Section 316, the term “dividend” refers to any distribution of property (including cash) made by a corporation to its shareholders from its earnings and profits (E&P). E&P generally refers to taxable income that’s adjusted for certain tax-exempt income and certain disallowed losses that were accumulated after February 28, 1913, or out of its E&P for the current taxable year without regard to the amount of E&P at the time the distribution was made. These rules can apply to other types of entities, but the Qualified Dividend concept and E&P are somewhat specific to C Corp dividends.

However, when investors are presented with their annual Form 1099-DIV, they often encounter both “Qualified” Dividends and “Non-Qualified” Dividends.

So what is the distinction?

In 2003, The Jobs and Growth Tax Relief and Reconciliation Act (The 2003 Act) made a significant reduction to the maximum tax rates at which Qualified Dividends and Long-Term Capital Gains received by individuals, estates and trusts were taxed. The lower rates, introduced by The 2003 Act, maxed out at 15 percent (vs. the normal 20 percent capital gain rate), with certain taxpayers enjoying a zero-percent rate. The lower rates were based on the tax bracket that a particular taxpayer fell into.

Fast forward to 2012, and The American Taxpayer Relief Act (The 2012 Act) made permanent the lower rates introduced by The 2003 Act. The 2012 Act also re-introduced the 20 percent tax rate to be applied to higher-income taxpayers.

For the tax year 2018, the maximum taxable income taxpayers can earn while still enjoying the zero-percent rate are as follows, based on the taxpayers’ specific tax filing status:

FILING STATUS

MAXIMUM TAXABLE INCOME FOR 0% RATE ON QUALIFIED DIVIDENDS

Single

$38,600

Joint

$77,200

Head of Household

$51,700

NOTE: When taxable distributions are made from tax-deferred accounts such as IRAs, qualified retirement plans, and annuities, they are generally recognized as ordinary income by the recipient, to the extent that the distribution exceeds the taxpayer’s basis. Therefore, the reduced tax rates introduced by The 2003 Act, and made permanent by The 2012 Act, are not eligible for dividends received by such accounts. Rather, they are taxed at normal rates. With this in mind, to the extent that a taxpayer invests in domestic and certain foreign stocks which will generate “Qualified Dividends”, these stocks may be better placed in taxable accounts rather than in IRAs, SEPS, etc. since no capital gain benefit will be achieved in the tax-deferred accounts.

Although we now understand that Qualified Dividends enjoy a preferential tax rate, we still haven’t defined the term “Qualified Dividend.”  According to IRC § 1(h)(11)(B)(i), the term “Qualified Dividend income” means dividends received during the taxable year from domestic corporations, and qualified foreign corporations.” As such, generally, distributions from domestic C Corporations are considered Qualified Dividends to the extent of E&P. However, an S Corporation may only have accumulated E&P if it was a C Corporation in prior years and still has retained C Corp E&P. Therefore, distributions from S Corporations will seldom be considered Qualified Dividends.

NOTE: When an S Corporation receives Qualified Dividends from a subsidiary or from portfolio investments and passes those dividends through to its shareholders, the shareholders may potentially enjoy the lower tax rates afforded Qualified Dividends regardless of whether the S Corporation made any of its own distributions to its shareholders.

Suppose your investments include foreign corporations – a fairly common occurrence in most portfolios. Per IRC §1(h)(11)(C), “the term ‘qualified foreign corporation’ means any foreign corporation if such corporation is incorporated in a possession of the United States, or such corporation is eligible for benefits of a comprehensive income tax treaty with the United States which the Secretary determines is satisfactory for purposes [of the reduced tax rates on dividends] and which includes an exchange of information program.”

NOTE: IRS Notice 2011-64 provides the current list of treaties that are considered to meet the above requirements.

Now that we are somewhat familiar with the rules surrounding the issuer of would-be Qualified Dividends, we are all set, right? Not so fast. There are also requirements at the recipient level that must be met in order to meet the definition of Qualified Dividend and to enjoy those bargain lower tax rates.

Dividends are generally not eligible for the lower tax rates afforded Qualified Dividends unless the recipient holds the underlying shares for a specific period of time. A common misconception is that the underlying shares must be held for longer than one year in order for any related dividends to be taxed as Qualified Dividends.

In order to be eligible for the lower rates on Qualified Dividends, the owner must hold the underlying stock for greater than 60 days during the 121-day period beginning 60 days before the “ex-dividend” date. The “ex-dividend” date is the day on which all shares bought and sold no longer come attached with the right to receive the most recently declared dividend. There are several important distinctions to consider:

  1. The holding period includes the date of disposal, but not the date of acquisition.
  2. The holding period does not have to be consecutive.

NOTE: The holding period requirement is slightly expanded for preferred stock dividends attributable to a period, or periods, aggregating more than 366 days. In these instances, the requisite holding period is more than 90 days during the 181-day period beginning 90 days before the stock’s ex-dividend date.

Real Estate Investment Trusts (REITs)
As REITs generally pay no entity-level tax, in most instances any dividends issued by REITs will not be eligible for the reduced rates that are afforded to Qualified Dividends. However, there are several important exceptions:

  1. Dividends issued by a REIT that are attributable to dividends received from taxable non-REIT corporations after 2002 will generally qualify for the lower rates, and
  2. Dividends issued by a REIT that are attributable to income on which the REIT paid tax should also qualify for the lower rates (reduced by the amount of tax the REIT paid on the above taxable income).

Mutual Fund Dividends

Generally, most distributions from mutual funds will be referred to as dividends. However, distributions from mutual funds will only qualify for the reduced tax rate to the degree that the amount is determined to be a Qualified Dividend which is received by the mutual fund. Mutual fund distributions that are comprised of items such as short-term capital gains and interest will not qualify for the lower rates. However, distributions comprised of long-term capital gains from the underlying fund portfolio will qualify for the lower rates.

Tax Planning Opportunity – Giving Up Qualified Status for Greater Tax Benefit
Form 4952 is used to figure the amount of investment interest expense a taxpayer may deduct in a given tax year. Per IRC §163(d)(1), investment interest expense is generally deductible only up to the amount of net investment income. For this purpose, Qualified Dividends are generally not considered investment income since such dividends are taxed at the favorable long-term capital gains rate. However, an election can be made by taxpayers who wish to treat their Qualified Dividend income as investment income--and thereby increase the amount of investment interest expense eligible to be deducted on their Form 4952.

NOTE: If the above election is made when filing your personal return, any dividends treated as investment income will not qualify for the reduced tax rates afforded Qualified Dividends. This essentially provides a choice of applying the lower tax rates to Qualified Dividends, or instead, for using the Qualified Dividend income to offset investment interest expense.

Conclusion
Admittedly the rules described above are complex. In most instances, taxpayers rely on the designations of “Qualified” or “Non-Qualified” dividends that they receive on their respective Form(s) 1099-DIV. This is done in order to place reliance on the required holding periods of the underlying stock and therefore on the favorable tax rates that are afforded to Qualified Dividends. It is important to note that, technically, it is up to the taxpayer (and/or the taxpayer’s preparer) to be absolutely certain that the underlying stock meets all the requirements for Qualified Dividend treatment.

About the Authors
Blake Christian, CPA, MBT is a partner in the Long Beach, California and Park City, Utah offices of HCVT. He can be reached at BlakeC@hcvt.com  |  435-200-9262
Justin Salley is a Supervising Senior Tax Accountant in the Long Beach, California office of HCVT. He can be reached at Justin.Salley@hcvt.com  |  562-216-5521

For Further Information
Blake Christian
T: 435.200.9262
F: 435.100.9277
BlakeC@hcvt.com

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