Since 2003,
individuals have had a tax incentive to buy stocks that pay
dividends. Instead of being taxed at an individual's regular
income tax rate as it was in the past, most dividend income
qualifies for a highly favorable federal rate. For many investors,
the rate difference amounts to a
substantial reduction in the tax they have to pay on their dividend
income.
The Difference
The top
federal income tax rate on ordinary income (compensation, interest,
rents, etc.) is currently 35%. Qualified dividend income, on the
other hand, is taxed at a maximum rate of 15% through 2008. In dollars, a rate differential of 20 percentage points
amounts to a tax savings of $200 for every $1,000 of dividend income
received.
An even
lower rate of just 5% applies to dividend income that otherwise
would be taxed at 10% or 15%. In 2008, the 5% rate drops to 0%,
meaning that individuals in the 10% or 15% regular tax brackets will
pay no federal income taxes on dividends received in 2008.
Holding Period Requirements
To ensure
favorable dividend treatment, an investor needs to hold the
underlying stock (or mutual fund shares) for a minimum period. In
general, the minimum holding period is 61 days during the 121-day
period beginning 60 days before the stock's ex-dividend date. (A
stock's ex-dividend date is the date on which it begins trading
without rights to the most recently declared dividend.)
Business-related Planning
The
historically low 15% rate also presents owners of closely held
corporations with an opportunity to withdraw earnings and profits
(E&P) from their corporations at a relatively modest tax cost. In
certain situations, paying a dividend may be highly beneficial from
a tax planning perspective.
Avoiding termination of an S election.
An S corporation that has accumulated E&P from years in which it
operated as a regular C corporation can lose its status as an S
corporation if, for three consecutive years, the corporation
generates net “passive” investment income (e.g., royalties, rents,
gains on security sales) that exceeds 25% of gross receipts.
Eliminating the E&P by distributing low-taxed dividends would
eliminate the corporation's exposure to the passive income
restrictions.
Avoiding accumulated earnings tax.
The IRS can assess an accumulated earnings tax penalty on
corporations that accumulate excessive amounts of income to avoid
making taxable dividend distributions to shareholders. Because the
tax penalty is scheduled to increase significantly after 2008,
reducing accumulated earnings by paying dividends could be a useful
strategy.
