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New Rates

While the new law does not eliminate the double tax on dividends, it does provide tax relief to those individual taxpayers who receive corporate dividends. Under the 2003 Act, dividends are taxable at the same rates as net capital gains. And the tax rates on those capital gains are going down — from 20% to 15% and from 10% to 5%.

The capital gains rate cuts are effective for tax years ending on or after May 6, 2003, through the end of 2008. The 5% rate will be 0% in 2008. (In effect, then, the new capital gains rates will apply to sales and exchanges and payments received on or after May 6, 2003, and before January 1, 2009.) The holding period to qualify for the new 15%/5% rates is more than one year. The old law’s 18%/8% rates are repealed, but return after 2008 for qualifying gains.

The dividend rate cuts are effective for tax years beginning after 2002 and before 2009. For tax years beginning after 2008, both dividends and capital gains will be taxed as they were before the 2003 Act. A transitional rule applies for capital gains realized before May 6, 2003.

Example: Ross, who is in the highest tax bracket, realizes net long-term capital gain of $150,000 and qualified dividend income of $50,000 in 2004. Prior to the 2003 Act, Ross would have had to pay tax on his gain at a 20% rate and on his dividends at a 37.6% rate. Under the new law, both his gain and his dividends will be taxed at a 15% rate. So, his tax will be approximately $30,000 on that income instead of approximately $48,800 under prior law.

The new dividend rates apply to dividends received by an individual shareholder from a domestic or “qualified foreign” corporation (one whose stock is traded on an established U.S. securities market or meets certain criteria).

If a shareholder does not hold a stock for more than 60 days during the 120-day period beginning 60 days before the stock’s ex-dividend date, dividends on that stock will not qualify for the reduced rates. Among the other special rules that apply:

  • Amounts treated as ordinary income on the disposition of certain preferred stock are treated as dividends eligible for the reduced rates.
  • For purposes of the investment interest deduction (which is generally limited to the amount of net investment income realized during the year), a dividend will qualify as investment income only if the taxpayer elects not to use the reduced rates for the dividend.
  • The reduced rates are not available for dividends to the extent a shareholder is obligated (through a short sale or otherwise) to make related payments with respect to positions in substantially similar or related property.
  • The amounts of qualifying dividends that may be paid by a real estate investment trust or regulated investment company are limited in some cases.
  • The reduced rate doesn’t apply to dividends received from an organization exempt from tax under Section 501 of the tax code or that was a tax-exempt farmers’ cooperative in either the taxable year of the distribution or the previous taxable year.
  • Neither does the reduced rate apply to dividends received from a mutual savings bank that received a deduction for dividends paid on deposits nor to deductible dividends on employer securities held by a qualified Employee Stock Ownership Plan (where the dividends are distributed to plan participants).

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