D'oh!
The Qualified Dividend Glitch
Why millions of investors will overpay their taxes this year.
Updated February 13, 2004.
Every year there's an issue that makes a mess out of the tax
season. This year it's a glitch in the way the rules were
written for the dividend tax break.
Beginning this year we get to pay a lower tax rate on most
dividends. The rates are the same as for long-term capital
gains: 5% when dividends fall in the lowest tax brackets and 15%
otherwise. But there was a mistake in the way the law was
written. Because of this mistake, you could overpay your taxes
if you follow the rules set forth in the instructions for your
tax return, and in certain IRS information publications. What's
more, the dividend information you received from your mutual
fund investments may be incorrect.
The IRS has now said it's OK to report your dividends as if
the mistake did not appear in the law. Yet it isn't practical
for them to send everyone corrected instructions. They'll post
corrected instructions online. Meanwhile you have to be prepared
for the possibility you'll receive something from your mutual
fund company saying the first numbers they sent you weren't
exactly accurate.
61 Days
The problem relates to the requirement to hold the shares at
least 61 days. Congress didn't want you to (1) buy shares just
before the ex-dividend date, (2) receive a dividend taxed at
15%, and (3) immediately sell the shares for a short-term
capital loss that might save you as much as 35%. So the rule is
that you have to hold the shares at least 61 days if you want to
claim the lower rate on your dividend.
Well, it isn't enough just to hold the shares 61 days. You
have to hold them during a 61-day period that includes the
ex-dividend date. But that isn't quite what the law says. What it says
is you have to hold the shares more than 60 days during the
120-day period beginning 60 days before the ex-dividend date.
Let's see what happens when you buy stock on the day before
the ex-dividend date and hold the shares 63 days. You get the
dividend, of course, because you bought before the ex-dividend
date. But is it a qualified dividend? It's gotta be,
right? You bought the stock before the ex-dividend date, you
received the dividend, and you held the shares more than 60
days. But there's a problem.
You Run Out of Time
Whenever we figure your holding period for something under
the tax law, we include the day you sold it but not the day you
bought it. That's why you can't claim a long-term capital gain
until you hold something until the anniversary of the day
after the date of purchase. When we apply that rule here,
your ownership of the stock begins on the ex-dividend date, the
day after your purchase. You have to hold the shares 61 days
during the 120-day period beginning 60 days before the
ex-dividend date. Well guess what? Sixty of those days are already
gone, and that means there are only 60 days left, and that means
you can hold the shares until the cows come home, even the mad
cows, and you still won't have a qualified dividend, because you
held the shares less than 61 days during that 120-day period.
D'oh!
Technical Corrections
Of course this isn't the way the law was supposed to work.
Congress has figured this out
and plans to correct the mistake, and make the correction
retroactive. Let's all pretend the law said 121 days instead
of 120 days, right from the start. But Congress hasn't had
time to pass the technical corrections law yet, and no one told
the IRS there was going to be a correction for this problem
until after the forms came out for this year. So there it is
on page 23 of the Form 1040 instructions, an example
showing that you can't claim a qualified dividend if you
buy shares the day before the ex-dividend date, even if you hold
the shares more than 60 days.
Meanwhile, brokers and mutual funds have presumably geared up
to report according to the erroneous (but legal) 120-day rule
rather than the correct (but not yet legal) 121-day rule. I'm
guessing the tax software companies have done the same thing.
Using the crudest possible estimate I figure that during the
past year at least a billion shares, and probably more like 2
billion, were purchased on ex-dividend dates.
Where Things Stand
The IRS has announced that we can act as if the technical
correction has already passed. In other words, we can ignore
this part of the instructions to Form 1040 (and Form 1041 and so
on). They won't be able to send out corrected instructions, but
they'll post corrected instructions on their web site. They'll
also post amended versions of the information publications that
are affected. At this writing, all we have is an informal
announcement on their web site (click
here), but a formal announcement should appear shortly.
What to Do
You can now feel comfortable ignoring the part of the Form
1040 instructions explaining what happens if you bought shares
on the day before the ex-dividend date. If that's your only
issue, go ahead and file your return as if the correction were
in place. If you received nonqualified dividend income from a
stock mutual fund, you may want to check with the company to
find out if corrected tax information is on the way. You can
have nonqualified dividends for other reasons, so you shouldn't
expect to see the entire amount switched to the better category.
Yet there may be cases where the corrected information will save
you some money.
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