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Dividend Income: How is dividend income taxed?

dividends, dividend income, taxing dividends, how to tax dividends, are my dividends taxed, how are dividends taxed, dividend taxationStock ownership results in dividend income. U.S. tax code defines a dividend as a distribution of property (cash or property) by a corporation to a stock owner. The tax code specifies that the distribution comes from the company's earnings and profits (E&P). The specification is important because the source of the distribution determines the taxability of the dividend income [side note: taxability should definitely be a word].

The company should alert you of the source of the dividend income. Additionally, the company will take care of the dividend distribution accounting. So, it is not necessary for you to understand dividend tax accounting. However, in my opinion, it is always helpful to have a basic understanding of tax-related topics. So, I will briefly discuss the tax accounting rules relating to dividend distributions.

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Dividend Income

Dividend Income Taxability: What is the source of the dividend income?

As I stated, the source of the dividend determines the taxability of the dividend income. Specifically, the availability of E&P and your stock basis determine how the dividend income is taxed. If the dividend distribution comes out of E&P, then normal rules apply, and the dividend income is taxed like a normal taxable dividend. If the distribution does not come out of E&P (no E&P available), then the dividend income is not taxable, but instead, the dividend distribution decreases your stock basis in the company. Lastly, if the dividend distribution does not come from E&P, and you lack sufficient stock basis in the company, then the dividend distribution is taxed like capital gain income. Please see the summary of the rules below:
  • E&P: Yes → taxable dividend
  • E&P: No → Stock basis: Yes → nontaxable dividend and stock basis reduced (ROC)
  • E&P: No → Stock basis: No → taxable capital gain

Taxable Dividends: What amount to include in gross income?

A company may distribute dividends in a variety of forms. For example, a company may distribute a cash dividend, a property dividend, or a stock dividend. When it relates to taxable dividends, cash dividends and property dividends apply. If you receive a cash dividend, you should include the amount received in gross income. If you receive a property dividend, you should include the fair market value of the property in gross income.

Taxable Dividends: What is the tax rate for dividends?

Qualified dividends receive a special tax rate. Therefore, you will pay a lower tax rate on your qualified dividends. Make sure to research if your dividends qualify as qualified dividends. If so,
the qualified dividend tax rate ranges from 0% to 20%. Specifically, lower-income taxpayers pay a 0% tax rate on dividend income. Higher-income taxpayers pay a 20% tax rate on dividend income. Those taxpayers (most) in-between pay a 15% tax rate on dividend income. The special rate tax brackets can be found on the IRS website.

What about tax-free distributions?

A company distribution to a stockholder may be tax-exempt. If so, you will not include the distribution amount in gross income. The following items should be tax-exempt distributions.
  • Return of Capital (ROC): if the company does not have E&P, and you have sufficient stock basis, you treat the distribution like a return of capital. A return of capital is not included in gross income.
  • Stock dividend: A stock dividend does not result in a taxable event. The stock dividend will cause an adjustment in your stock basis in the company based on the class of stock distributed. An exception to this rule exists if the stock dividend has cash/property options attached. If so, the stock dividend is taxable at the FMV of the dividend. 

In conclusion

The tax law surrounding dividend income is somewhat complex. The company will be in charge of accounting for the source of the dividend distribution. Remember that the accounting rules differ based on the source of the dividend. Additionally, taxable dividends should be included in gross income. However, the taxable dividend amounts will be taxed at special, lower tax rates.

I hope you furthered your understanding about dividend income and the related dividend distribution tax accounting concepts. Please share with others who may also benefit from learning more about how dividends are taxed.

Please comment below if you have any questions or comments relating to dividend income!
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