Tax Analysis of Dividends

Transcription

1 Tax Analysis of Securities Transactions July, 2015 Tax Analysis of Dividends George Michaels, CEO & Founder, G2 FinTech 1

2 Course Description and Learning Objectives In this course, you will learn about several rules for computing the tax status of dividends. After this course, you will be able to: Determine if and when a dividend becomes qualified (QDI). Determine whether a dividend is eligible for the Dividends Received Deduction (DRD). Identify diminished risk of loss and calculate date adjustments for QDI and DRD. Calculate the tax status of a dividend paid through a short position (263(h)).

3 Presenter and Reviewer Bios Presenter: George Michaels, Founder & CEO, G2 FinTech An authority on tax analysis of securities transactions, Mr. Michaels shares his subject matter expertise at industry conferences, and his commentary regularly appears in financial trade and major media publications. Mr. Michaels also authors white papers and articles on complex tax issues and industry trends. Reviewed by: C. Daniel Stubbs, CPA C. Daniel Stubbs, Jr., CPA, Assistant Professor and Director, Master of Accountancy in Financial Accounting, Rutgers Business School. Mr. Stubbs is a former member of the Executive Committee of the NYSSCPA Board of Directors and past Executive Secretary of the NY State Board for Public Accountancy.

4 Overview Dividend Rules Qualified Dividends Dividends Received Deduction Short Dividends

5 Qualified Dividends Qualified dividends, as defined by the United States Internal Revenue Code, are ordinary dividends that meet specific criteria to be taxed at the lower long-term capital gains tax rate rather than at higher tax rate for an individual's ordinary income The specific rules are stated in Section 1(h)(11) which references 246(c). Qualified dividends are taxed at a maximum rate of 20%. The 20% rate is for income in the 39.6% tax bracket. Nonqualified dividends are taxed as ordinary income (currently a 39.6% maximum). Taxpayers are also subject to a 3.8% Medicare surtax on net investment income (which includes all taxable dividends) above a threshold.

6 The QDI Rule Holding Period You must hold (unhedged) a position in the dividend-paying security for 61 out of a possible 121 days surrounding the exdividend date. Hedges can suspend the holding period. Hedges include short positions, stock options, swaps and other securities which reduce risk of loss from the dividend paying security. Qualified Covered Calls do not count as hedges. For certain dividends on preferred stock, the security must be held for 91 days out of the 181-day window. This longer window applies when a dividend from a preferred stock is attributable to a period longer than a year.

7 The QDI Rule Reminder: The specific rules are stated in Section 1(h)(11) which references 246(c). The dividend must be paid on a domestic corporation, or a qualified foreign corporation. Note: 901(k) governs foreign withholding on dividends. Interestingly 901(k) is similar to QDI in that it has a 16 of 31 day window to be eligible for a tax credit. If the taxpayer lent out the stock, and receives a payment-in-lieu of dividend, this is not qualified. If the taxpayer makes a payment relating to this dividend (e.g. is also short the stock, and makes a PIL), the dividend is not qualified. Certain dividends on which no tax was paid originally are not qualified. Some examples are any dividend from tax-exempt organizations and farmers co-ops.

8 QDI Example 1 A Taxpayer buys 100 shares of XYZ Corporation on 05/15/2009. XYZ produces a dividend whose ex-date is 07/09/2009. The Taxpayer sells all her shares of XYZ corporation on 07/24/2009. The dividend qualifies because the Taxpayer held the shares for 70 days (05/15 to 07/24) out of the available 121 days (05/10 to 09/07).

9 QDI Example 2 A Taxpayer buys 100 shares of XYZ Corporation on 05/15/2009. XYZ produces a dividend whose ex-date is 07/09/2009. On 07/10/2009, the Taxpayer buys a put option (December Expiration) on XYZ that allows her to sell all her shares at a set strike price. The Taxpayer sells all her shares of XYZ corporation on 07/24/2009. The dividend fails to qualify because the Taxpayer held the shares unhedged for 56 days (05/15 to 07/10) out of the available 121 days (05/10 to 09/07). The days from 07/10 through 07/24, do not count because the put option diminishes the risk from holding the XYZ shares.

10 QDI Example 3 A Taxpayer buys 100 shares of XYZ Corporation on 05/15/2009. XYZ produces a dividend whose ex-date is 07/09/2009. On 07/10/2009, the Taxpayer buys a put option on XYZ that allows her to sell all her shares at a price close to the current market price of XYZ. On 07/20/2009 the put option expires worthless. The Taxpayer sells all her shares of XYZ corporation on 08/01/2009. The dividend qualifies because the Taxpayer held the shares unhedged for 68 days (05/15 to 07/10) + (07/20 to 08/01) out of the available 121 days (05/10 to 09/07). The Taxpayer is allowed to add together the days before and after the hedge to determine whether or not the dividend qualifies.

11 QDI Example 4 A Taxpayer buys 100 shares of XYZ Corporation on 05/15/2009. The Taxpayer s custodian lends the shares of XYZ to another customer to facilitate a short sale. XYZ produces a dividend whose ex-date is 07/09/2009. The taxpayer receives a payment in lieu of the dividend. The Taxpayer sells all her shares of XYZ corporation on 07/24/2009. The dividend fails to qualify because although the Taxpayer held the shares for 70 days (05/15 to 07/24) out of the available 121 days (05/10 to 09/07), the dividend was never paid to the Taxpayer, but instead she received a payment in lieu which cannot qualify.

12 Overview Dividend Rules Qualified Dividends Dividends Received Deduction Short Dividends

13 Dividends Received Deduction In order to minimize multiple layers of taxation, a corporation may receive a tax deduction for a dividend paid to it by companies in which it has an ownership stake. The purpose of this deduction is to soften the consequences of triple (or more) taxation. Multiple layers of taxation can occur when a company paying the dividend does so with after-tax money and the receiving company also pays a tax on the dividends. If the receiver then pays a dividend in turn to another corporation (or shareholder) then three or more layers of taxation can occur. Although all these layers of taxation can make politicians very happy, they serve as a strong disincentive for corporations to pay dividends, particularly when some of their shareholders are also corporations. The primary DRD rule is governed by section 243 of the IRC.

14 The DRD Rule The DRD rule applies to corporations that receive dividends. The rule allows corporations to pay potentially less tax on the dividend. The DRD rule is mostly the same rule as QDI with 45 day window (46 of 91) Security Qualification rules are somewhat different than QDI. Like with QDI, in certain cases preferred dividends receive a 91 of 181 day window. Generally, if a corporation receives dividends from another domestic corporation, it is entitled to a deduction of 70% of the dividend it receives. If the corporation receiving the dividend owns 20% or more, however, then the amount of the deduction increases to 80%. If, on the other hand, the corporation receiving the dividend is part of the same affiliated group as the distributing corporation, it is allowed to deduct 100% of the dividend it receives.

15 DRD Example 1 ABC Corporation buys 100 shares of XYZ Corporation on 06/15/2009. XYZ produces a dividend whose ex-date is 07/09/2009. ABC Corporation sells all its shares of XYZ Corporation on 08/04/2009. The dividend qualifies for DRD treatment because ABC Corporation held the shares for 50 days (06/15 to 08/04) out of the available 91 days (05/25 to 08/23).

16 DRD Example 2 ABC Corporation buys 100 shares of XYZ Corporation on 06/15/2009. XYZ produces a dividend whose ex-date is 07/09/2009. On 07/10/2009, ABC Corporation buys a put option on XYZ that allows it to sell all its shares at a set strike price. On 07/20/2009 the put option expires worthless. ABC Corporation sells all its shares of XYZ Corporation on 08/15/2009. The dividend qualifies for the deduction because ABC Corporation held the shares unhedged for 51 days (06/15 to 7/10) + (07/20 to 08/15) out of the available 91 days (05/25 to 08/23). ABC Corporation is allowed to add together the days before and after the hedge to determine whether or not the dividend is deductible.

17 Overview Dividend Rules Qualified Dividends Dividends Received Deduction Short Dividends

18 Short Dividends Normally, if a taxpayer holds a short position which pays a dividend, the dividend can be deducted as an investment expense. However if the taxpayer holds the position less than 46 days, no such deduction may be made. Instead the taxpayer receives a basis adjustment on the position. A basis adjustment is less desirable for the taxpayer as it is less flexible than a business expense deduction. This rule is governed by section 263(h) of the IRC.

19 The 263(h) Rule No deduction is allowed if the taxpayer held the short for less than 46 days before covering (trade date to trade date) instead you take the dividend as a basis adjustment. Hedges to the short can suspend the holding period in an analogous way that hedges can suspend the holding period with QDI and DRD. Unlike QDI/DRD there is no window. The 46 days can be satisfied at any time (even potentially years later). Extraordinary dividends require a one-year un-hedged holding period to qualify as an expense.

20 Short Dividends Example 1 A Taxpayer sells short 100 shares of XYZ stock on 05/15/2009. XYZ produces a dividend whose ex-date is 07/09/2009. The taxpayer must make a payment in lieu for the full extent of the dividend to her custodian. The Taxpayer covers the XYZ short on 07/10/2009. The holding period for the short is 56 days (05/15 to 07/10). Therefore, dividend may be taken as an investment expense deduction by the taxpayer.

21 Short Dividends Example 2 A Taxpayer sells short 100 shares of XYZ stock on 06/15/2009. XYZ produces a dividend whose ex-date is 07/09/2009. The taxpayer must make a payment in lieu for the full extent of the dividend to her custodian. On 07/10/2009, the Taxpayer purchases a call option with an 10/15/2009 expiration date. The call option allows the Taxpayer to purchase 100 shares of XYZ at a set strike price. The option expires worthless on 10/15/2009. The taxpayer maintains the short position on XYZ stock for the remainder of the year. The unhedged holding period for the short is more than 45 days (05/15 to 07/10) + (10/15 to 12/31). Therefore, the dividend may be taken as an investment expense deduction by the taxpayer. Note, there is no window for determination of the 46-day holding period and that if needed, the taxpayer would have been allowed to claim days in 2010 towards the 46-day requirement.

22 Summary Ruled by Benefit QDI DRD Short Dividend Section 1(h)(11), which references 246(c) Maximum tax rate of 20%, rather than ordinary tax rate Sections 243 and % or more deductible, rather than ordinary tax rate Section 263(h) May be deducted as an expense, rather than held as basis adjustment Applicable for All Taxpayers Corporations Only All Taxpayers Holding Period Window 61 days 91 days for certain preferred stock 121 days around ex dividend date, 181 for certain preferred stock 46 days 91 days for certain preferred stock 91 days around ex dividend date, 181 for certain preferred stock 46 days None

23 Questions? Thank you for attending our presentation on Tax Analysis of Dividends.