Interest & Dividend Income?
(I think I am going to have a headache!)
I distinctly remember being taught in Business 101 that interest is what the company pays on its debt and whatever a company pays shareholders out of its profits is called a dividend. Oh, sure, we were told about something called tax-exempt interest in Taxation 101, and that this was generally issued by a governmental entity, but that was about the extent of the discussion.
When I started my career as a CPA, I thought I knew it all. All I had to remember was to put the stuff we call dividends on the dividend income line on the tax return and the stuff called interest on the interest line. What could be simpler?
What a difference a few tax laws can make. Let’s see, not only do we have our old friends interest and tax-exempt interest, but we also have tax-exempt interest from private activity bonds, original issue discount bonds and even something called imputed interest. On the dividend side, we have qualified dividends, dividends that would be qualified except that you haven’t held the stock long enough, non-qualified dividends, qualified foreign dividends and an unusual type of income called a "payment in lieu of dividends."
And what a difference a name can make! That’s what we are going to explore this month. Now a word of caution to all the C Corporations out there - this does not fully apply to you because you don’t get a break on dividend income any more than you get a break on capital gains. Only individuals will get to use the lower dividend and capital gain rates and, since their income is passed through to the individual, S Corporations, Partherships and LLCs will need to identify the different types of income. Sure this is unfair, but it is consistent with the prevailing philosophy in Washington, D.C. that all corporations are essentially evil. On the bright side, at least the new rules don’t unnecessarily complicate the C Corporation’s income tax return.
Let’s get on with our tour of the various income tax returns one might file and where interest and dividend income are reported on those forms.
For individuals, interest will generally be reported on either line 8a or 8b of Form 1040. Depending on the amount of interest, you may also be required to file Schedule B to your 1040. Generally, you must file a Schedule B if you had over $1,500 of taxable interest or dividends, claim an exclusion of interest from series EE or I U.S. Savings Bonds issued after 1989, received ordinary dividends as a nominee or had a foreign account or received distributions from a foreign trust. If you received interest as a nominee or from a seller-financed mortgage, you will also need to file a Schedule B.
Where you are required to enter income from interest is extremely important. Taxable interest goes on line 8a and is included in the computation of taxable income. Tax-exempt interest and tax-exempt interest received as dividends from mutual funds are reported on line 8b. For income tax purposes, there is no tax on tax-exempt interest, but the Alternative Minimum Tax does tax any tax-exempt interest from private activity bonds. For an individual, Alternative Minimum taxable interest is reported on Line 11 of Form 6251. Don’t worry about how you will figure out how much private activity interest you had, your annual 1099-INT and 1099-DIV will tell you.
Oh, by the way, have you bought any corporate or U.S. Government bonds that were issued at a discount. This happens when the stated interest rate is less than the going market rate or, sometimes, bonds are issued at a low value and mature many years later with the difference between the purchase price and maturity value being the interest return on the bond. If you have these kinds of bonds, you most likely have an item on your 1099-INT called Original Issue Discount ("OID"). Essentially, what the brokerage house is doing is recording a little bit of the OID as interest each year until the bond reaches maturity. Then, when the bond matures, there is no gain or loss - in theory. In the real world, calling bonds or other dispositions of OID bonds quite often results in a gain or loss.
Are you thoroughly confused yet? If not, we may need you here preparing tax returns, but only if you can navigate the remainder of the rules about taxable and non-taxable interest income. Space doesn’t permit me to get into all the rules, so I will quit here...well...there is one more thing. Don’t be fooled by the term tax-exempt. Interest may be tax-exempt, but you still have to report it on your return. There are some tax calculations that add tax-exempt interest to other income to determine the taxability of income. Most prominent is the inclusion of Social Security benefits in income.
If you are looking at the tax return of a pass-through entity like an S Corporation or a Partnership, you will first see the interest on Schedule K of those returns. In turn, each partner/shareholder/member will receive a K-1 with their share of income, including interest and dividends, on it.
Dividends are wonderful creations of law in the hands of a shareholder. In very simple terms, they can be affirmation of one’s wisdom in investing in a company (assuming the stock price doesn’t drop too much). Unfortunately, recent tax laws have taken away that simplicity and created a complex new entity called the qualified dividend. Simply put, a qualified dividend is a dividend that is taxed at a maximum of 15% (5% for those in a tax bracket of less than 25%), but getting to whether a dividend qualifies for the lower rate is an art form in itself.
If you have dividend income, chances are you received a 1099-DIV from either the payer of the dividend or your broker. The company that sends the 1099-DIV should tell you on the 1099 whether dividends are qualified or not.
There now, that really wasn’t that hard after all, was it? It would be easy if that were where you had to stop. Unfortunately, there are also certain "holding period" requirements. In order for a dividend to qualify, the stock on which the dividend is paid must be held for more than 60 days in the 120-day period that begins 60 days before the ex-dividend date and 60 days after the ex-dividend date. The ex-dividend date is the first date following the declaration of a dividend that the buyer of a stock will not receive that dividend. It gets a little trickier for certain preferred stock. We will be glad to discuss the various rules with you.
Another little rule you will have to remember is that dividends from foreign corporations do not qualify for the lower rate, unless they are from certain countries. You can find a list of these countries in IRS Publication 17 at the IRS website.
There are certain types of corporations that pay dividends that are specifically excluded from the qualified dividend category. You can find a list of these entities in Publication 17. In addition, there are several other types of dividends, including, payments in lieu of dividends, that may not qualify for the lower rates. Payments in lieu of dividends result when a brokerage company "borrows" your stock and a dividend is paid while the brokerage has your stock. Since you don’t get the dividend, the brokerage pays you what you would have received and calls the deal even. The only problem is it can cost you tax and you basically have no control over when a brokerage will borrow the stock.
Since we are running a little long here, let’s get to the reporting requirements. You already know about the rules for Schedule B, so all you need to know now is that taxable dividend income is reported on 9a in total and the portion of line 9a that qualifies for the lower rate is included on line 9b. As with interest, if you have dividend income coming from a pass-through entity, you will get a K-1 telling you how much dividend income you need to report.
I just spent approximately 1,300 words trying to explain just a few concepts related to interest and dividend income. Can you believe that I have only scratched the surface? It’s true. As time goes by and laws change, one of the hallmarks of good tax legislation seems to be complexity. If you have dividend or interest income, perhaps it’s time to give us a call. Let us 1) help you understand the law and b) help you best plan to take advantage of the current tax law. Perhaps that will help you avoid a headache on April 15.
Have a great March and don’t forget to keep our troops in your thoughts and prayers.