Did you receive a 1099-DIV and are wondering why there are boxes separating ordinary (non-qualified) dividends and qualified dividends? In this article, we will first define dividends and then explain the differences between qualified and non-qualified dividends.

What is a dividend?

When a company has net profits (income leftover after paying all expenses), it must decide whether to keep those profits and reinvest them into the business or return a portion of those profits back to its shareholders in the form of a dividend. Management and the board of directors make that decision if they believe that retaining the profits will allow them to grow faster by investing in existing or new projects. If the company cannot find new growth opportunities, then it will decide to give a portion back to shareholders. For example, Coca Cola pays out over 70 percent of its profits because it can no longer find new markets to invest in to grow the company. As a result, shareholders prefer to have the dividend so that they can invest the cash as they choose. Lastly, dividends can be in the form of cash or stock.  

Unlike Coca Cola which is a mature company, shareholders in growth oriented companies such as Tesla or Amazon prefer to have the company reinvest the net profits because the company is growing quickly and can reinvest the profits for a higher rate of return. Such shareholders also do not want the dividend paid out because they will have to pay tax on the dividend, either stock or cash.  

What is the difference in taxation between qualified and non-qualified dividends?

Both qualified and non-qualified (also known as ordinary) dividends are subject to taxation, but they are taxed at different rates. Taxes on qualified dividends are more favorable and mimic long-term capital gains tax rates, which are currently at 0%, 15%, and a maximum of 20%. Whereas, non-qualified or ‘ordinary’ dividends are taxed at the less favorable ordinary income tax rates, which can reach a staggering 37%. Obviously, shareholders prefer qualified dividends over non-qualified. 

What if I get an unexpected dividend?

Unexpected dividends, also known as extra dividends, occur when a company experiences serendipitous growth, cannot reinvest its cash, and doesn’t want its cash to sit on the books. Uninvested cash is a non-earning asset so shareholders prefer the company to hold as little cash as possible. For example, Microsoft and Apple have both paid special dividends in the past when their cash hoard has built up so much that shareholders demanded that the companies either reinvest the cash or pay it out to shareholders. Special dividends can benefit a company’s relationship with its shareholders since it’s a display of confidence in generating cashflow, the bloodline for any business.

Conversely, special dividends can cause unexpected tax consequences for shareholders because the dividends are taxable. Shareholders of growth companies that do not pay dividends can create their own dividends by essentially selling a portion of their stock. This allows shareholders to manage the timing of their tax liability as well as the amount of tax because a shareholder can choose to sell longer term holdings for more favorable tax rates.

What are qualified dividends?

According to the IRS, the following requirements must be met for a dividend to be considered qualified: 

1. The dividend must be paid from a US corporation or a qualified foreign corporation. A qualified foreign corporation is one that is incorporated in the US; is eligible for an income tax treaty with the US; OR, the stock is readily traded on a US exchange.
2. The dividend cannot be a non-qualified dividend (discussed below). 
3. The shareholder must meet the holding period.

What are the holding periods?

The shareholder must have held the stock for at least 60 days during a 121 day period that begins 60 days before the ex-dividend date. The ex-dividend date is the first day after the day a shareholder is entitled to a dividend. 

The holding period for preferred stocks is similar, but preferred stocks have a slightly longer holding period.

The holding period is altered if you held a derivative instrument on the underlying stock.

Holding periods for mutual funds resemble those of common stocks with a critical difference; mutual funds specifically must hold unhedged securities 

What are nonqualified dividends?

Dividends are unqualified if they were:

• Those dividends that did not meet the requirements of a qualified dividend as previously mentioned.
• Capital gains distributions.
• Dividends paid on bank deposits, such as credit unions or savings and loans.
• Dividends from tax-exempt corporations or farmers cooperatives.
• Dividends paid to an ESOP (Employee Stock Ownership Plan).
• Dividends on stocks where you hold a short derivative position.
• Payments in lieu of dividends.
• Dividends paid by REITs or MLPs.
• Non dividend distributions, payment made that is not from earnings and profits.
• Liquidating dividends.

How do I know if my dividends are qualified or not?

You will receive an IRS form 1099-DIV from the company or your custodian at the end of the year. Qualified dividends would be shown in Box 1b whereas ordinary dividends would be in shown in box 1a. 

Closing Thoughts

Understanding the difference between qualified and non-qualified dividends can be taxing. Set yourself up for success by planning ahead, learning the requirements for qualification, and making time for holding periods.

Looking for an independent fiduciary financial advisor who can advise you on investments, retirement, real estate, alternative assets, and taxes? Contact ACap Advisors & Accountants to schedule a free initial consultation. Our clients include individuals, small businesses, entrepreneurs, and anyone serious about saving and investing for their future.