Many investors rely on dividends to generate much of their portfolio income. If you own stocks through a broker, your year-end tax forms might show some of the money you received during the year as a payment in lieu of dividends, listing it separately from your regular dividends. This can create a tax hassle that actually could cost you more at tax time. Below, you'll learn more about substitute payments in lieu of dividends and what you can do to avoid them.

How payments in lieu work
Substitute payments in lieu of dividends result from your broker lending out the stock you own to short-sellers. Those short-sellers borrow your shares and then sell them on the open market, betting that they'll go down in value before they have to repurchase them and return the shares to you.

If the stock pays a dividend during the period that they've borrowed shares, then the short-sellers have to reimburse you for the lost dividend income. This reimbursement is the substitute payment made in lieu of the dividends you would otherwise have received directly from the company issuing the stock.

The downside of payments in lieu
The whole point of payments in lieu of dividends is to make the original shareholder whole. However, there's a huge downside to payments in lieu: they don't qualify for favorable tax rates on qualified dividends. Currently, qualified dividends have maximum rates of 0% to 20% depending on your regular tax bracket, but they always save you at least 10 percentage points on the tax rate you pay on the dividends.

Payments in lieu don't qualify for that favorable treatment and get taxed at ordinary income rates. With those rates rising as high as 39.6%, payments in lieu can represent a costly tax problem.

How to prevent payments in lieu
There's a way you can make sure you'll never have to deal with substitute payments in lieu of dividends: choose a cash brokerage account rather than a margin brokerage account. In a cash account, your broker isn't allowed to use your shares to lend to short-sellers, preventing the payment in lieu situation from coming about. By contrast, a margin account usually includes provisions allowing your broker to lend your shares whenever it wants.

Substitute payments in lieu of dividends are important to income investors in that they ensure that you're getting the income you deserve. Nevertheless, the negative tax effect make payments in lieu something to avoid rather than something to embrace.

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