Questions on tax rule slow mailings

3/1/2004

SECOND OF FOUR PARTS

Business is a bit slower these days than usual for local accounting firms, but more than just client procrastination is to blame.

Determining what is a qualified dividend and one that's eligible for lower tax rates is confusing brokerage houses and mutual fund companies. As a result, they have either delayed mailing Form 1099-DIV to clients or likely will send multiple corrected statements, said local accountants.

There's also some question on whether Congress is going to slightly alter the 120-day window in which investors must own a stock in order to take advantage of the lower dividend rate.

Those uncertainties have, in turn, delayed when investors want to have their federal tax returns prepared this year in time for the April 15 deadline.

Still, changes in federal laws would seem to be a bonanza of savings for investors. Dividends are now taxed at either a 5 percent or 15 percent tax rate, depending on an investor's income. Before, dividends were taxed like regular income at rates as high as 38.6 percent.

The savings can be impressive: a filer in today's top tax bracket, 35 percent, with $1,000 in dividend income will owe $150 in tax instead of $350 before.

The problem with the apparent benefit to investors, however, is the definition of qualified dividends. Under the IRS definition, some so-called dividends are really interest, and thus taxed at the filer's regular income tax bracket. So, some brokers and mutual funds may send out corrected forms to reclassify what were originally called dividends.

"Because of the confusion associated with what are qualified dividends, I'm anticipating there will be multiple forms sent out," said Dave Baymiller, a tax partner at William Vaughn Co. in Maumee. Some tax preparers expect corrected 1099s to be sent out in the next few weeks, but Mr. Baymiller thinks it will last up until the tax filing deadline.

What makes a dividend "qualified?" Dividends from most domestic and foreign stocks qualify, but those paid by real estate-investment trusts or by the majority of preferred stocks (which technically are structured as bonds, not as equities) do not.

For mutual funds, the rules are more complicated. If the dividends are simply those paid by stocks held in the fund and passed through to investors, they qualify for the lower rate.

If they are dubbed "dividends" but are really short-term capital gains, or are interest from bonds, they do not qualify. The key is to check the 1099. If the dividend is listed in box 1a, it doesn't qualify, but if it is listed in box 1b, it does qualify.

To make it more complicated, dividends received from a mutual fund are considered "qualified" depending on the holding period. To take advantage of the 15 percent rate, the stock or fund must be owned more than 60 days within a 120-day window around the date which the company or fund says investors must own the security to receive the dividend.

The reason behind the rule is the IRS doesn't want quick traders to get a tax break on the dividend. In other words, someone buying a stock, collecting the dividend, and then selling a slumping stock almost immediately to claim a capital loss, wouldn't be able to use the 15 percent rate.

Gregory Hendel, a partner in the Maumee CPA firm Hendel & Zuchowski, said, "Generally, [the rules] make sense logically, but tracking it is going to be very difficult."

The complexity requires more work to calculate capital gains and losses. Thirteen lines have been added to Schedule D, the 1040 form used to report such gains and losses. The schedule has an 11-page instruction booklet.

Distributions of long-term capital gains from mutual funds are eligible for a new 15 percent rate, beginning May 5, 2003, compared to 20 percent previous, if the fund has been owned for more than one year.

Distributions of short-term capital gains continue to be reported as ordinary dividends and taxed at regular income tax rates.

Average investors may have fewer capital gains this year than in previous years in part because the stocks in many mutual funds offset gains last year by carrying forward previous losses, thus cutting their own taxes. The result means smaller gains for investors.

Some taxpayers may be able to avoid Schedule D altogether. The IRS said last month it had changed a special worksheet that goes along with Forms 1040 and 1040A to expand the number of taxpayers who can use it and avoid Schedule D to report capital gains and losses.

For 2003, the form, included in the tax booklet instructions, can be used for both qualified dividends and the new, lower capital-gains rates enacted last year. It applies, however, only to filers whose investment income is solely from dividends or to those whose capital gains are limited to distributions reported in box 2a or 2b of the 1099s.