I have a dog; his name is Tax. When I open the door, in come Tax!

It's that time of year again. The Taxman is a-comin' and he'll be a-collectin'. Are you ready? Let's review some of the issues that Drippers encounter as we get ready for April 17 (this year's filing deadline since April 15 is on a Saturday).

Dividends

In the majority of years, your Drip-related tax concerns will be limited to dividend income received. Keep in mind that dividends received, whether reinvested in a reinvestment plan or cashed in order to buy Bazooka Joe Bubble Gum, is income paid to you and will be taxed accordingly.

For each company that you Drip, you will generally receive a 1099-DIV form at the end of the year, stating how much you received in dividends. If the amount of dividend income received is less than $10, many companies will not send a 1099-DIV form. You will, however, still be expected to report any dividend income received. If you do not receive a 1099-DIV, your year-end account statement will list the total dividend income for the year.

If the total of dividend income received is greater than $400, you will need to fill out Schedule B (Interest & Ordinary Dividends). Otherwise, you'll list dividends on your usual 1040 form.

If you did not sell any shares held in a Drip in 1999, that should wrap up any tax reporting associated with direct investing for this year. You can stop reading now. Go outside and work on those lawn sculptures. Spring is right around the corner.

Capital Gains and Losses

This is where the fun begins. If you've sold any shares in a Drip in 1999, you will need to know the prices paid for each share and partial share sold and the length of time that you held each share and partial share. This is why you've saved all those year-end statements all these years. Recordkeeping. Recordkeeping. Recordkeeping. Can't stress enough how important it is to keep good records when Drip investing.

Now, assuming you want to use FIFO (first in, first out), rather than Specific Identification of Shares, and you have all your purchase amounts and holding lengths in front of you, you'll want to separate anything held less than one year from the rest. These will be your short-term holdings. Everything else will be your long-term holdings. For each holding period, add up the number of shares sold and the cost bases of all those shares. Subtract the combined cost basis from the proceeds of the sale to calculate your gain (or loss). You usually want to use FIFO to easily maximize holding periods and pay a lower tax rate.

On Schedule D, you will list each group of shares sold by holding period. For the purchase date, write "various dates." Record the amount paid for each block and the amount of gain or loss for each time period. That's all there is to it. Good records and a digital abacus will do wonders to obviate mid-April headaches.

Dividend Purchases

Sometimes confusion results from purchases made with (reinvested) dividends. These are to be treated the same as purchases made with money from your checking account or cash from the sale of lemonade. Each dividend purchase will have its own cost basis, just as every optional cash purchase or initial purchase does. Purchases from dividend income will be added with all other purchases in the previous step.

Commissions

There are two kinds of commissions that you will encounter in direct investing. Both have tax-reporting implications:

Commissions Paid by You: These should be added to you purchase basis, and any commissions incurred in the sale should be deducted from the proceeds. This will benefit you by decreasing your tax liability.

Commissions Paid by the Company: Even if a plan is fee-free, often the company will pay a commission on your behalf when purchasing shares. This is considered by the IRS to be income paid to you, and you will be expected to report it. Look on your 1099-DIV form or year-end statement for these, as well.

Investment Fees

If, instead of a commission, you incur a fee associated with the production of income (investing), it should not be a part of your cost basis. Instead, you may list fees as a deduction on Schedule A, subject to the 2% of Adjusted Gross Income (AGI) limit.

Help

Have questions or concerns regarding investing and taxes? Here are a few sources of aid and inspiration:

  • Motley Fool Tax Area
  • MF Investment Tax Guide
  • Tax Strategies message board
  • Internal Revenue Service (IRS)
  • Tax Man Max Rhyme

    That wraps up the basics of Drips and taxes. Again, the key element is recordkeeping. With good records, a calculator, and a cozy afternoon to spare, your tax return preparation will be a breeze.

    Drip on, Fools!