There are many types of dividends, but they generally consist of distributions of cash, stock, or other property paid to a taxpayer by a corporation. Most dividends consist of cash, but they can be distributions of more stock, stock rights, other property, or even services.

Ordinary Dividends

A taxpayer can assume that any dividends received on common or preferred stock are ordinary dividends unless the corporation informs him otherwise. Ordinary dividends are paid from the earnings and profits of a corporation, and they are taxable as ordinary income, not as a capital gain, to the recipient.

Qualified Dividends

Congress has recently reduced the tax rate on certain qualified dividends. Under the new law, qualified dividends are ordinary dividends received after 2002, and they are taxed to individuals, estates, and trusts at the new lower capital gain tax rates (5% or 15%). The new rates do not apply to dividends passed through from fiscal year partnerships, S corporations, or estates with fiscal years beginning in 2002, even if received in 2003.

To qualify for the reduced maximum rate, the dividends must have been paid by either a U.S. corporation or a qualified foreign corporation. In addition, they cannot be of a type specifically excluded from the beneficial treatment, and the taxpayer has to have owned the stock for a statutory holding period.

The taxpayer must hold the stock for at least 61 days of a 120-day period in order to take advantage of the reduced tax rates. That period begins 60 days before the day a stock trades without its dividend (the "ex-dividend date"), and ends 59 days after the ex-dividend date.

In the case of preferred stock dividends attributable to periods of more than 366 days, the taxpayer must hold the stock for at least 91 days of a 180-day period. That period begins 90 days before the ex-dividend date, and ends 89 days after the ex-dividend date.

Dividends That Are Not Qualified Dividends

If a taxpayer receives a dividend that is of a type listed below, he is not entitled to apply the reduced tax rate:

  • Capital gains distributions.
  • Dividends on deposits with certain banks and savings and loan associations.
  • Dividends from a tax-exempt organization or farmer's cooperative.
  • Dividends paid on employer securities held by an employee stock ownership plan.
  • Payments in lieu of dividends if the taxpayer knew or had reason to know that the payments were not qualified dividends.

Dividend Reinvestment Plans

If a taxpayer can choose to use his dividends to buy more stock in the corporation at its fair market value instead of receiving cash payment, the dividends must be reported as income. If the plan allows the taxpayer to buy additional stock at less than its fair market value, the taxpayer must report the fair market value of the additional stock as income.

Nontaxable Distributions

  • Return of CapitalIf a corporation pays back a portion of the taxpayer's investment rather than distributes earnings and profits, the payment is nontaxable until the full amount of the investment had been returned.
  • Distributions of Stock and Stock RightsInstead of distributing cash dividends, some corporations give their investors more shares of their own stock or the right to purchase more shares (stock options). Generally, stock dividends and stock options are not taxable.

Copyright 2012 LexisNexis, a division of Reed Elsevier Inc.