You may know by now that you'll benefit from a lower tax rate on qualified dividends, thanks to this year's tax cuts. But there are some exceptions to this general rule. As I've previously discussed, not all dividends are created equal. Some may qualify for the lower tax rate, but some may not. It depends on a number of factors.
One of the barriers to a lower dividend tax rate occurs when you loan out your shares of stock to another person who might be selling the stock "short." If you loan out your shares in such a manner, the payments that you actually receive are considered "in lieu" payments and not dividends. The person who holds the shares (the person to whom you loaned your shares) receives the dividend. Then that person makes a payment to you in lieu of the dividend that you missed. And "in lieu" payments don't qualify as dividends received, and therefore don't qualify for the lower tax on dividend income.
"Who cares?" you might mumble. "I never loan my shares out to anybody, so none of this applies to me." But that's very possibly not the case, if you maintain your stocks in a brokerage account under the "street name." And for most people, this is exactly how they hold their investments. When you hold your stock in this manner, it's possible that the brokerage firm is taking some of your stock -- without your knowledge -- and loaning it out to other investors who are shorting a particular stock. You might not realize it's happening until you receive your broker statement at the end of the year indicating that you've received "payments in lieu" rather than dividends.
You agreed to this when you opened your account if you signed the broker's standard agreement, which generally allows the broker to lend shares held in street name without notifying the customer (you). So you likely gave them your approval to do this without even realizing it. Back in the days before the lower tax rates on dividends, it was immaterial if you received an actual dividend or a "payment in lieu" since they were all taxed at the same rates. But now it's extremely important.
IRS Notice 2003-67 addresses this situation. It basically states that brokers will be required to report both regular dividends and "in lieu" payments on the 1099-DIV form for 2003. The dividends will qualify for the lower tax rates, the "in lieu" payments will not. But this notice also states that if you receive a statement from the broker indicating that all of your dividends are qualifying, you can rely on this statement when you prepare your 2003 tax return.
So what can you do to make sure your dividends are eligible for the lower tax rate? Some financial publications have gone so far as to suggest that you hold all dividend-paying stocks in your own name and in a safe deposit box. I'm not so sure I'd go that far. I like the flexibility of having my shares held in street name. If you've ever tried to sell stock for which you held the actual certificate, you understand what I mean about convenience.
If you don't want to hold all of your dividend-paying stocks in your own name, and you also like the convenience of keeping your shares in street name, you should take at least take some steps to ensure that your dividends will qualify for the lower tax rate. Those steps include:
- Read your brokerage agreement: Hopefully you can find it among your stacks of important papers. If you can't, ask your brokerage to send you a copy. See if your brokerage agreement allows your shares to be loaned.
- Maintain a cash account: If you don't purchase stock on margin, see if your broker will allow you to open a simple cash account. In many cases, straight cash accounts will not allow the broker to loan out your shares.
- Keep your margin account inactive: If you do have a margin account with your broker, and you don't need to use it, don't. Generally speaking, most brokers won't loan out your securities unless you have a margin account and you have a debit balance in that margin account (i.e., you owe money to your broker). So even if you do have a margin account, it's possible that your shares will not be loaned out unless you've activated the margin provisions and owe your broker money.
- Require prior approval: It's possible that your broker will be agreeable to amending your brokerage agreement to prohibit your shares from being loaned without your prior written approval. That's something you'll have to work out with your broker.
Regardless of your course of action, you should be aware of the risk that you might be assuming when holding your dividend-paying stocks in street name. Make sure you understand how your brokerage account works, and if your broker can loan your shares. If it can, and it won't change its ways, it might be time to find another broker who will.
Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though