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Tax Professionals Face Problems Reporting 2003 Dividends

By Eugene H. Fleishman

Payers and reporters of dividend income who have to file Internal Revenue Service form 1099-DIV, and taxpayers and tax preparers who are responsible for correct reporting on tax returns, will face several new reporting problems due to the changes contained in the Jobs and Growth Tax Relief Reconciliation Act of 2003.

Dividend income for 2003 will be taxed at a maximum rate of 15 percent, with a 5 percent rate for those taxpayers in the 10 and 15 percent tax brackets. These favorable tax rates, however, are available only for what the act describes as “qualified dividend income,” which new IRC Section 1(h)(11) defines as “dividends received…from domestic corporations and qualifying foreign corporations.”

This new code section contains exceptions that prevent the favorable taxation of what one would normally think of as a qualified dividend. Following is a list of the exceptions that might cause problems for taxpayers and reporting corporations, trust companies, brokerage houses, mutual fund companies and other preparers of 1099-DIV.

Holding Period Rule

Qualified dividend treatment will not be available unless the taxpayer holds a stock for more than 60 days during the 120-day period beginning 60 days before the ex-dividend date (the date following the record date on which the corporation finalizes the list of shareholders who will receive the dividend).

This exception was inserted to prevent receipt of preferential dividend treatment followed by claim of a short-term capital loss, which could potentially be offset against other income taxed at higher rates. Without this exception, a taxpayer could generate tax savings even though he sustained no economic loss on the stock. The lower rate will be available for stock purchased prior to the ex-dividend date, as long as it is held for more than 60 days.

Is the payer of a dividend to know how long a taxpayer has held his shares? The instructions for the 2003 1099-DIV box 1b (Qualified Dividends), which state that the box should contain the portion of the total dividends that qualify for the 5 and 15 percent rates, also say that the box should include dividends for which it is impractical to determine if the holding period has been met.

Investment companies with actively managed accounts could potentially have software in place to track this for a taxpayer or client. Some of them already have been doing this for wash sales, but even if they do have the software, it might not catch all situations; for instance, if the taxpayer purchased shares toward the end of the calendar year and sold them in the following year within the 60-day holding period limit. Tax preparers will have to request sale information for January, February and March of the following year in order to see if the taxpayer has complied with the holding period rule.

Short Sale/Related Dividends

Qualified dividend income does not include dividends on any share of stock to the extent that the taxpayer is under an obligation (whether pursuant to a short sale or otherwise) to make related payments with respect to positions in substantially similar or related property (New Section 1(h)(11)(B)(iii)(II)). This restriction is identical in wording to the previously existing restriction of the dividends received deduction, which C corporations can claim under IRC Section 246(c)(1)(B).

If only a portion of the holdings is sold short, then the net amount of the dividend received, after payback of the dividend on the shares sold short, can be considered qualified dividend income. The 1099-DIV instructions do not provide any guidance for this particular fact pattern. It is very likely the entire dividend will be reported as qualified, so that the onus for reflecting this correctly on the tax return will be placed on the taxpayer or the tax preparer.

Investment Income Election

Qualified dividend income will not include any dividend income reported by the taxpayer as investment income for purposes of deducting investment interest, including margin interest. This exception will override any otherwise qualifying dividend reported on the 1099-DIV. The taxpayer must affirmatively elect to report qualifying dividends as investment income. This could pose a problem for taxpayers who are not vigilant in preparing their returns. It is easily possible to report more dividend income than needed as investment income, thereby needlessly taxing those dividends at higher rates.

Waiver of Penalties

The House/Senate Conference Agreement contains a paragraph that allows the IRS to waive any penalties under the information reporting requirements of Sections 6042 and 6045 for brokers and dealers who engage in securities lending transactions, short sales and other similar transactions on behalf of their clients. No mention is made about waiver of penalties for taxpayers or their advisors for incorrect reporting.

Conclusion

The proper reporting of dividend income for 2003 (and probably succeeding years) will likely be very time-consuming for taxpayers who own a significant number of shares in publicly owned dividend-paying companies. Clients should be alerted to this problem so they are not surprised that their tax preparation fees are substantially higher because of all the additional work required to report dividends properly and in the most tax-advantageous way.

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Eugene H. Fleishman, CPA, a sole practitioner in Poughkeepsie, N.Y., has been a member of the Income of Estates and Trusts Committee since 1993.