 Hello, and welcome to this session in which we will discuss the taxability of dividends. We have two types of dividend, ordinary dividend and qualified dividend, and in this session we will try to explain the difference between ordinary dividend and qualified dividend. But first we have to understand what is a dividend? What is a dividend? A dividend is a distribution of property, usually cash, or could be non-cash, made by a corporation to its shareholder. The assumptions always, dividend is paid out of earnings and profit. What does that mean? It means the company generates revenues, then they incur expenses, then they have a profit. Hopefully they'll have a profit, in other words, more revenues than expenses. The question is, what do you do with this profit? Well, you can keep for the company, or you can distribute to shareholders. And when you distribute the profit to shareholders, it is called a dividend. And this is the basic idea of dividend. Now, from a shareholders' perspective, the dividend income obviously would represent a profit generated from the investment of the stock. So why did you receive this cash? Well, because you invested in the stock. So you always have to have to own the stock. And usually when you have the stock, you have a basis, you have an investment in the stock. That's the assumption. Now, bear in mind that unlike interest, dividend do not accrue on a daily basis. And you don't qualify for dividend. In other words, as long as the corporation don't declare dividend, you don't qualify just because you own the stock. Because the company itself, the board of directors, will have to declare it. The company could have billions and billions of dollars, and they choose not to pay you dividend. It's only dividend when they declare it. In other words, when the company decides to pay you that dividend. And dividend are generally taxed to the party who's entitled to receive them. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool. That's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions, as well as exercises. Go ahead, start your free trial today. No obligation, no credit card required. Not every payment made by the company is dividend. Why? Because remember dividend comes out of earnings, out of earnings and profit. And what is earnings and profit for tax purposes? Think of retained earnings. In other words, the company made the profit. What are they going to do with this profit? As long as it's coming out of earnings and profit. In other words, the company is profitable. Then it's taxable as dividend when they give you this distribution. What happens if the company will have no earnings and profit? However, they do pay you some money. They want to share some of the cash with the shareholders. That's fine. If they have no earnings and profit, what's going to happen is it's called return of capital, return of capital, or ROC. And it's going to reduce your basis, ROC. Simply put, let's assume you have an investment of $100,000. That's your basis. And the company distributed $25,000. But the company has no earnings and profit. But they distributed $25,000 to you. Well, if that's the case, then since it's not dividend because they have no earnings and profit, you would reduce your basis to $75,000. Simply put, what they did, they gave you $25,000 of the $100,000 of your stock basis. What happened if the company has no earnings and profit and your basis now becomes zero? You have no basis and you have no earnings and profit. At this point, they're giving you way above your investment. They gave you back all your investment, plus more. Well, what does that mean? It means you are experiencing capital gains, then it's taxed at capital gains. So distribution could be dividend, which is taxable. If it's coming out of EMP, it could be return of your basis. And remember, that's non-taxable because if they're giving you back your money, that's not taxable. And if they're giving you more than your money, what you invested in and no profit and earnings is available, then it's taxable as capital gains. Now, the first one is a taxable, but how is it taxable? We're gonna see the dividend could be taxable as ordinary or the dividend could be taxable as qualified. And this is what we need to get to. How about stock dividend? Well, stock dividend is when the company, rather than give you cash, they'll give you the option to get stock dividend. Not the option, sometimes they give you the option sometimes not. Usually companies pay cash, usually company pay cash. But sometimes what they do is rather than pay you cash, they give you additional stocks. In other words, the company, they want to keep their cash, but they want to reward you. They want to reward the shareholder. So if you're a 10% owner of the company and they want to distribute 1,000 new stocks and you're a 10% owner, you'll get 100 of these shares. So it's proportionate to your ownership. Well, here's what's gonna happen. If option given between stock dividend and cash, the amount is taxable. So sometimes the company would say, look, would you like us to give you 100 new shares or $2 per share or $200? Well, if they give you this option, then the $200 or the 100 shares are taxable. If no option is given, so they would say we're gonna give you stock dividend and we're not giving you the option to get cash. No option is involved. If that's the case, then you can't pay the IRS because you don't have the option to get the cash, then the stock dividend is not taxable. So the stock dividend is only taxable when you have the option to receive the cash. The reason is simple, because the IRS, they want you to pay taxes if you have access to the money. And when they give you the option, they gave you access to the cash. And the IRS would say you have the ability to pay us, therefore the amount is taxable. If the option is not taxable, basically it's the same basis. So what's gonna happen, those new additional 100 stocks that you received, now you have 1,100, now you have 1,100 shares, but the amount that you invested in those shares are the same, so you still have the same basis. We need to be aware of three dates when it comes to dividend. And the three dates are, the declaration date is the first one, that's the first one, or the date on which, the date, the board of directors declared the payment of dividend. Remember what we said? We said there's someone at the company and that's the board of directors. The people who are in charge of the company, they will declare, they would say now we decided to pay dividend, that's the declaration date. And let's assume for the sake of illustration, that date is November 25th, that's the declaration date. Then we have a second date, and that's the record date. What is the record date? That's an important date. They're all important, but that's also another date. The date which, also known as the cutoff date, a dictate which shareholders are eligible for the corporate dividend. So I'm gonna put this date, December the 10th. What does that date means? It means you have to own the stock as of December the 10th. If you want to qualify to receive the dividend, you have to be on record December the 10th. This is the records date. Why? Because if you are on that date, you are on our record as an owner, you will get the dividend. Now, there's another date we need to be aware of, which I will discuss in a moment, but before we discuss that ex-dividend date, ex-dividend date, there's obviously a payment date. And the payment date, let's assume I'm gonna make it actually December 25th, Christmas Day. That's your gift, right? That's your gift from the corporation. This is when they actually pay you the dividend. So this is the payment date. It's simply put, it's the date that the company pay you the dividend. Those are the three dates. Records date, the declaration date, records date, and payment date. Now, we need to be aware of the ex-dividend date. What is the ex-dividend date? If you buy the stock on the ex-dividend date, you don't qualify for the dividend. So what's the ex-dividend date? It's one business day before the record day. So what's one business day before the record day? Let's assume 12, 10 is a business day, and it's not Monday. Let's assume this is a Thursday. Then Wednesday, if this is a Thursday, I'm just making this up, if this is a Thursday. So Wednesday is 12, nine is the ex-dividend date. So one business day before the record date. Why is that important? Well, we're gonna see later. So what is the ex-dividend date? Well, if you buy the stock on December the 9th, well, you are not an owner on the 10th. That's the ex, you're not gonna receive the dividend. Why? Because it takes more than a day for the stock to settle. So if you buy the stock today, you're not really an owner today. So you're not owner on the 10th. So you're gonna lose the dividend because you're not owner on the 10th. That's what the ex-dividend date means. You buy the stock, you don't receive the dividend. So just know it's the one business day before the record date. Why is that important? We're gonna see later because we're gonna be using this term ex-dividend date. Now, dividend on stock transferred by gift. Now remember, you can get stock by buying the stock or you can get a stock by someone gifting you the stock. If someone gift you the stock after the declaration date but before the record date, so what's the, what are we looking at here? We're looking after the declaration date is after November 25th, but before the record date, before December the 10th. Let's assume somebody gifted you the stock on December 2nd. Well, the record date are taxed to the donor. The original owner of the shares, not the donning. What happened under those circumstances, the person that gave you the stock is responsible for paying the stock dividend. This does not apply if the stock was sold, I'm sorry, this does not apply if the stock was sold not gifted. So if it's gifted, the person that gave you the gift is responsible for the taxes. Again, the sold stock, we talk about the rules. You just, you need to be aware of the rules when it comes to gift, okay? If the, this does not apply if the stock was sold, in which case the dividend income would be taxable to the new owner. If you bought the stock on December 12th, well, you are as of record as of December the 10th, you are responsible for paying taxes. But if that stock was gifted to you, and what's the, what's the assumption here? The assumption is the person that's gifting you the stock, they don't want the income because they don't want to be taxed. Therefore it says, well, if it's gifted, you are still responsible because you gifted it after the declaration before the record. That's what we're saying here because they don't want you to shift the taxable to someone else by gifting the stock. I hope you see the point. Let's take a look at an example. On June 15th, the board of directors declared a dividend of $20 per share. Well, let's look at a timeline here. And this is June 15th. This is the declaration date. The dividend is payable on July 1st. This is July 1st. So you have to own the stock on July 1st. I'm sorry, payable July 1st. And the record date is June 28th. As of June 15th, Sarah owned 500 shares of ABC Company. On June 17th, which is two days later, so let's see what Sarah did, sold 250 shares to Raji at their prevailing fair market value of 310 per share and gifted the remaining shares to her niece Maria. So here she got root of the 250 by a gift and the 250 by a sale. What's gonna happen now? Based on this information, determine who's responsible for paying the tax on the 500 shares, which is $10,000 of dividend income, 500 shares times $20 per share. Well, guess what? I hope you know the answer. When she gifted the shares, the assumption is she's trying to give the shares to Maria so she would avoid paying the taxes, which is guess what? Sarah will be responsible for the taxes. But since she sold the shares to Raji, Raji is, as of the record date, he owns the stock. As of, assuming he doesn't sell the stock by June 28th, Raji is responsible for paying the dividend. So out of the total 500, 250 were sold and 250 were gifted on June 17th. June 17th falls between the declaration date and the record date, which is a special date. Therefore, Raji is entitled to receive the dividend for the 250 and responsible for paying the taxes. However, Sarah remained responsible for the 250 shares that she gifted to Maria because the assumption here is she's trying to get rid of her ownership. Now let's talk about the types of dividend. There are two main types of dividend and the reason we went through this because I want you to understand what dividend is. I want you to understand the X date because this is what we're gonna be using this information. We have ordinary and unqualified and qualified dividend. Well, we say ordinary, it's unqualified, but we say really it's ordinary and qualified. But in case they use the word unqualified, it's the same thing as ordinary, okay? Now, bear in mind, however pays you dividend, the payer of the dividend should identify the type on the amount of the dividend to you. So when you receive at the end of the year, at 1099, the IV, which I will show you in a moment, the form, they will tell you this amount is ordinary, this amount is qualified. So this way the taxability of these two amounts are different. The taxpayer then should include the dividend received on form 1040. Well, whether they put it under the qualified dividend or ordinary dividend. There's also a place on the 1040 where you will place this information. Then you might have to also prepare schedule B, you attach to 1040 if it's more than 1500. And I showed you the schedule B when we discuss interest income. So I showed you this. So this is basically the 1099 DIV. Notice I always block the years. Notice it says total ordinary dividend, total qualified dividend. So the payer, so let's assume this is from your Bank of America or Merrill Lynch or whatever fidelity. They will tell you exactly how much of the dividend is ordinary, how much of the dividend is qualified. Now, they also have to tell you if there's any federal income tax withheld, if there's any section 1202, total capital gain distribution, so on and so forth. But we're here with discussing only ordinary dividend and qualified dividend. Now this ordinary dividend and qualified dividend will also have to be listed on your Form 1040. Let's take a look at Form 1040. And this is Form 1040. Again, for a different year, it might look slightly different, but here's the qualified. This is where you put the qualified dividend. And this is where you put the ordinary dividend. Again, why do you differentiate between the two? Because they are taxed differently. How differently and why we're gonna see in a moment. Starting with ordinary or unqualified dividend, ordinary dividend. Those are taxed at ordinary income tax rate. That's easy, ordinary dividend, ordinary income tax rate should be straightforward. What does that mean? It means any dividend you receive is considered wages. It's taxed as wages, not considered wages, it's taxed as wages. Why wages? Because wages is taxed based on your ordinary income tax rate. Whatever your ordinary income tax rate is, the income that you received is taxed on that level, just like interest income. If interest is taxable, it's taxed on your ordinary rate. So dividend are not eligible for the preferential tax treatment. In other words, we have different type of dividend, different type of dividend rate for qualified dividend. So dividend that are not eligible for preferential treatment, which is applicable to qualified dividend are the following. Dividend from certain foreign corporations. So when do you receive ordinary dividend? When the corporation is a foreign. Now not all foreign corporations, some foreign corporation might give you qualified dividend. We'll talk about that. Dividend paid on employee stock options. If you have employee stock options and you receive dividend from them, that doesn't qualify. Dividend from certain US entities such as credit union, real estate, investment trust, those have special rules. They cannot give you what we considered qualified dividend. Dividend that do not satisfy the holding period. And this is important because to satisfy the holding period means you qualify for the, assuming it's coming from the qualified corporation, then you have the holding period requirement. So what is the holding period? Simply put, to be eligible for the qualified dividend, the stock on which the dividend are paid must have been held by the taxpayer at least 60 days during the 121 period, beginning 60 days before the ex-date. Now, we already learned about the ex-date. So let's see, remember the ex-date is one date before the record date. So if this is the ex-date, it's again, the ex-date is one day before the record state. So what do you have to do in order to qualify for this? Well, you have to have owned the stock 60 days before this date. So if you own it 60 days, if you own it 60 days, then you are eligible. Let's assume you buy it before the ex-date right here, closer to the ex-date. If that's the case, you have for the next 121 days, you have to own it 60 days. But first you have to buy it before the ex-date. And if it's 60 days before the ex-date and you wait for it, that's it, you qualify. But if you buy it, for example, closer to the ex-date, then going 121 days from the date that you purchased it, including the ex-date, you have to own it for 60 days. Simply put, what we're trying to say here, you have to hold it at least two months, 60 days is two months, that's the key. But those two months, they have to fall starting before the ex-date. That's basically what we mean by the time eligibility. So qualified dividend are taxed differently. So if you do have a qualified dividend, they are taxed at the preferential tax treatment, which is the long-term capital gains, which is what, either zero, 15 or 20%. And we talked about long-term capital gains in a separate session, when do you qualify for zero, 15 and 20%, depending on your income bracket and your tax filing status and taxable income. There are different brackets for this. So dividend from foreign corporation, they could be eligible only if the foreign corporation stock is traded on an established US stock market. For example, the Japanese car manufacturer and company, Toyota, it's a Japanese company, but they are traded in the US, therefore, although they're foreign, they could give you qualified dividend, or the foreign corporation is eligible for the benefit of a comprehensive tax treaty with the US. And for example, Toyota, we do have a tax treaty with Japan. So they qualify under both. In addition to be a qualified dividend, the stock on which the dividend are paid must have been held by the taxpayer at least 60 days. Remember when we said the 60 days during 121 period, beginning 60 days before the ex-dividend date. Simply put, you have to hold it for two months, and that two-month period has to start at least before the ex-dividend date. I hope this makes sense. Let's take a look at this example. August X3, XYZ corporation, distribute a dividend income of $3 per share to its common stock. Aside from the holding period, the distributed dividend meet the criteria of a qualified dividend. It means from a qualified corporation. On the distribution date, each of Jay and Jason owned 1,000 shares of the corporation. Jay satisfied the 60 over 120-day holding period, determined the appropriate tax treatment for the dividend received by each of the two shareholder, Jay and Jason. Given that Jason did not meet, only Jay met the holding period. If Jason did not meet this, then they will be taxed as dividend income based on the ordinary tax rate. So what does that mean? It means Jason, they could be taxed up to 37%. Based wherever their ordinary income is. However, since Jay received the preferential treatment because they held the stock for that two-month or 60 days in that holding period, it could be 0%. It could be 15%. It could be 20%. They qualify for the preferential tax treatment. What should you do now? Go to Farhat Lectures, look at additional MCQs. It's very important to distinguish between ordinary dividend and qualified dividend. Why? Because from a taxability perspective, one is taxed as ordinary income. The other one is taxed at a preferential tax treatment. You need to know the rules for the CPA exam, what type of corporation qualify, what type of corporation don't qualify. And you should be good to go, whether the CPA exam or enrolled agent exam. Good luck everyone, study hard and of course, stay safe.