Capitalizing on the lower dividend tax rate.

• Author: Ellentuck, Albert B.

The maximum tax rate on qualified dividends received by an individual, trust, or estate is 23.8% (base rate of 20% plus 3.8% net investment income tax for some high-income taxpayers). Dividends that would otherwise be taxed at the 10% or 15% ordinary income rate are taxed at 0% (essentially, they are not taxed). Thus, qualified dividends are taxed at the long-term capital gain rates. Identifying qualified dividends and helping taxpayers meet the requirements for qualified dividend status are valuable client services.

What Is a Qualified Dividend?

Qualified dividends are distributions of cash or property made by a domestic or qualified foreign corporation out of its earnings and profits (E&P) to a shareholder with respect to its stock (Secs. 1(h) (11)(B)(i) and 316).Therefore, distributions from domestic C corporations (to the extent of E&P) are generally qualified dividends. An S corporation, on the other hand, can have accumulated E&P only if it was formerly a C corporation or merged with a C corporation. Therefore, distributions from S corporations are often not qualified dividends because they are not made from E&P but instead represent a distribution of S corporation earnings. (However, qualified dividends that an S corporation receives are passed through to the shareholders and potentially taxed at the lower rates, regardless of whether the S corporation makes any shareholder distributions.)

Qualified Foreign Corporations

Qualified dividends include otherwise qualified dividends received from qualified foreign corporations. A corporation is a qualified foreign corporation if it is (1) incorporated in the United States or a U.S. possession, (2) readily tradable on an established U.S. securities market, or (3) eligible for benefits of a comprehensive income tax treaty with the United States that the Treasury secretary determines is satisfactory for purposes of the reduced tax rate on dividends and includes an exchange-of-information program (Sec. 1(h)(11)(C)).

Notice 2003-71 defines "readily tradable on an established securities market in the United States" to include common or ordinary stock, or an American depositary receipt in respect of such stock, if it is listed on the following securities exchanges: American Stock Exchange, the Boston Stock Exchange, the Cincinnati Stock Exchange, the Chicago Stock Exchange, the NYSE, the Philadelphia Stock Exchange, the Pacific Exchange Inc., or the Nasdaq Stock Market. (Several of these exchanges have merged or changed their names since the issuance of Notice 2003-71.)

Notice 2011-64 provides that the U.S. treaties with the following countries satisfy the requirements of Sec. 1(h)(11)(C): Australia, Austria, Bangladesh, Barbados, Belgium, Bulgaria, Canada, China, Cyprus, Czech Republic, Denmark, Egypt, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, India, Indonesia, Ireland, Israel, Italy, Jamaica, Japan, Kazakhstan, Korea, Latvia, Lithuania, Luxembourg, Malta, Mexico, Morocco, Netherlands, New Zealand, Norway, Pakistan, Philippines, Poland, Portugal, Romania, Russian Federation, Slovak Republic, Slovenia, South Africa, Spain, Sri Lanka, Sweden, Switzerland, Thailand, Trinidad and Tobago, Tunisia, Turkey, Ukraine, United Kingdom, and Venezuela. This list will be updated as appropriate. Note that a payer corporation must be eligible for the treaty benefits to be a qualified foreign corporation.

Dividends from a foreign corporation will not qualify for the reduced tax rate if they were paid by a foreign corporation that for the current or immediately prior tax year was a Sec. 552 foreign personal holding company, a Sec. 1246(b) foreign investment company, or a Sec. 1297 passive foreign investment company.

Any foreign tax credit allowed with respect to dividends eligible for the reduced tax rates will be scaled back under rules similar to those imposed by Sec. 904(b)(2)(B) relating to certain capital gains. This prevents the taxpayer from claiming a foreign tax credit greater than the U.S. tax paid on that income.

Passthrough Entities

Partnerships (including LLCs taxed as partnerships) pass qualified dividend income through to...