Investment tax planning for stocks takes advantage of the tax rules with the goal of achieving the best after-tax return on these investments. Strategies will differ depending on whether you purchase common stock or preferred stock.
Common stock is a form of equity that represents a share of ownership in a corporation. The shareholders of a corporation own the business and therefore benefit from its earnings, which can be distributed as dividends. If the business grows in value, shareholders can capitalize on this growth by selling their shares. Of course, shareholders also bear the risk that the business will decrease in value.
Essentially, there are four ways in which earnings on common stock may be realized:
Many corporations distribute periodic cash payments on their common stock. These payments are referred to as dividends. A dividend is a distribution out of a corporation’s current or accumulated earnings and profits. Why is this important? Corporations are taxed twice, once when the corporation earns income (at corporate income tax rates) and again when those earnings are distributed to shareholders as a dividend.
Qualifying dividends received by an individual shareholder from a domestic corporation or qualified foreign corporation are taxable at long-term capital gains tax rates. The reduced rates apply to both the regular tax and the alternative minimum tax.
Long-term capital gains and qualified dividends are generally taxed at special capital gains tax rates of 0 percent, 15 percent, and 20 percent depending on your taxable income. The actual process of calculating tax on long-term capital gains and qualified dividends is extremely complicated and depends on the amount of your net capital gains and qualified dividends and your taxable income.
This change in the law is advantageous to most investors who receive qualified dividends. Currently, a taxpayer in the highest marginal tax rate (37 percent) will be taxed on qualified dividends at a rate of 20 percent. That’s a 17 percent savings.
However, not all corporate distributions are entitled to tax-reduced dividend treatment.
Qualified dividends (eligible for capital gains tax treatment) are those that are received from domestic corporations and qualified foreign corporations. Corporate stock dividends passed through to investors by a mutual fund or other regulated investment company, partnership, real estate investment trust, or held by a common trust fund are also eligible. In addition, amounts received upon disposition of stock received as a nontaxable stock dividend that would otherwise be subject to ordinary income rules (i.e., IRC Section 306 stock) may qualify.
Tip: A qualified foreign corporation is one that is traded on an established U.S. securities market or is incorporated in a U.S. possession. A foreign corporation may also qualify if a comprehensive income tax treaty including a satisfactory exchange of information program exists between the United States and the corporation’s country. Countries that specifically do not qualify include Barbados, Bermuda, Cayman Islands, Costa Rica, Dominica, Dominican Republic, Grenada, Guyana, Honduras, Jamaica, Marshall Islands, Peru, Saint Lucia, Trinidad, and Tobago.
Dividends that are ineligible for capital gains tax treatment include payments that are typically called dividends but are actually interest. Interest received from savings accounts, certificates of deposit, corporate bonds, and U.S. Treasury securities is ineligible for the lower rates. Investors will pay taxes on this interest as ordinary income. Income from a tax-deferred vehicle, such as a 401(k) plan, IRA, or an annuity, is also ineligible even if the funds represent dividends from corporate stock held within the vehicle. The lower rates also do not apply to dividends paid by the following:
Further, dividends from preferred stock that is reported as debt and pays interest that is deducted by the corporation are not eligible.
Profit or loss from the sale of common stock is treated as capital gain or loss. Long-term capital gains benefit from preferential tax rates. To determine the applicable capital gains tax rate, you must distinguish between shares of stock held for different periods of time. Stocks held for one year or less generate short-term capital gains, which are taxed at the ordinary income tax rates. Stocks held over one year generate long-term capital gains that are generally taxed at special capital gains tax rates of 0 percent, 15 percent, and 20 percent depending on your taxable income.
Clearly, controlling the time (holding period) you own a share of stock and limiting income in a given year can result in tax savings. These and other timing strategies are discussed below.
Capital gain or loss from the sale of stock is determined by the difference between the amount realized and the tax basis. For most people, this means the difference between the amount you paid for the stock and the price at which you sell the stock. However, there are certain occasions when you must use special rules to determine your tax basis. These include the following:
Example(s): Assume Corporation X declares a 2-for-1 stock split. You own 100 shares that you purchased two years ago at $5 per share and that currently are worth $10 per share (or $1,000). After the stock split, you own 200 shares worth $5 per share (or $1,000). There is no gain on receipt of the additional shares.
A stock dividend, like a stock split, is a proportionate distribution of stock to all the shareholders. It essentially subdivides the stock.
Example(s): Assume Corporation X declares a proportionate 10 percent stock dividend. You own 100 shares that you purchased two years ago at $5 per share and that currently are worth $10 per share (or $1,000) before the split. After the stock split, you own 110 shares. These are worth approximately $9.10 per share (or $1,000). There is no gain on the distribution.
Your gain or loss on a subsequent sale is the difference between your cost basis and the sale price. How do you determine basis in your shares? Further, what is the holding period for these shares when there is a stock split or stock dividend? You must allocate the basis of the old shares between the old shares and the new shares. If you purchased several blocks of stock at different times, you must allocate the basis proportionately. In the first example, the $500 basis is allocated among the 200 shares. Thus, the basis per share is $2.50. In the second example, the $500 basis is allocated among the 110 shares. Thus, the basis per share is approximately $4.55 per share. The holding period is the same as for the old stock. If you purchased several blocks of stock at different times, you must allocate the holding period proportionately. In the above examples, the holding period is two years for all the stock.
Tip: If you are contemplating the purchase of a stock that has suffered consistent losses, you should have a sound investment reason for the purchase. In the short term, however, if the corporation continues to make cash distributions to shareholders, this may provide an opportunity for you to realize some of your investment return on a tax-free basis.
From time to time, a corporation may distribute property to its shareholders. As discussed above, you are generally not taxed on the distribution of a stock dividend issued on the corporation’s own shares. However, a distribution may be taxed if it is one of the following:
Distributions in complete liquidation of a corporation are taxable events. There are special rules for distributions in partial liquidation of a corporation and for certain corporate reorganizations. These distributions may be wholly or partially tax free. Distributions of other property owned by the corporation will usually result in gain but not loss. As a general rule, if the distribution is taxed, the basis of the distributed property is its fair market value. If the distribution is tax free, your basis will depend on specific tax rules.
Tip: Potential distributions of property may offer you the opportunity to defer or accelerate gain or loss, depending on the nature of the transaction. Likewise, purchasing or selling stock in anticipation of special distributions (depending on your personal situation) may provide you with tax advantages.
There are a number of other special tax rules for common stock. These include the following:
When you sell a stock short, you effectively borrow the stock from your broker and sell it in the hope that the price will decrease. You then purchase stock at the lower price, using these shares to repay your broker. If you purchase at a lower price, you have a gain. This is treated as short-term capital gain subject to ordinary income tax rates. If you purchase at a higher price, you generally have a short-term capital loss. A number of special tax rules apply to short sales.
Margin trading involves borrowing money from your broker in order to purchase a security. Interest charged on a margin account is deductible, but only when the interest is paid. The account is not unitary. Thus, you cannot report net gains and losses but must relate account items to each transaction.
Commissions, fees, and charges paid to acquire or sell shares of common stock are not deductible. Rather, these costs are added to tax basis. This either decreases your capital gain or increases your capital loss. These expenses generally cannot be used to offset ordinary income.
There are a number of tax planning considerations concerning common stock. These include the following:
For tax reasons, you should time your purchases and sales of common stocks much like you would with any other investment. Depending on your circumstances, you may seek to incur or avoid ordinary income or capital gain. As a general rule, you should prefer long-term capital gain to ordinary income because the rates are lower. However, if you have excess ordinary losses for a given year, you may very well want to incur dividend income. This underscores the importance of year-end planning. At the end of your tax year, you have the best idea of the amounts of your annual income, gains, and losses. You can then engage in a variety of transactions that will provide tax benefits. Of course, you can anticipate year-end results and execute a given sale or purchase at any time during the current year.
What are some planning opportunities with stocks? The timing of a stock sale controls all of the following:
Remember that your goal is to achieve the best after tax return on your holdings in common stock. Since the tax rates vary depending on the type of asset you own, how long you own it, and the type of income or gain you receive, your after-tax rate of return will also vary depending on these factors.
Investment selection relating to common stock centers on these factors. First, compare the growth and dividends of one common stock to another. Second, compare various types of common stocks to other investments such as bonds or mutual funds. Your time horizon, loss potential, and income tax bracket may increase or decrease the tax rate.
Investment tax planning for preferred stock takes advantage of the tax rules to achieve the best after-tax return on these investments. In some ways, preferred stock is like a loan. Generally, this type of stock is entitled to a preset or fixed dividend that is much more like interest than like a true dividend. However, the payment is usually financed out of earnings. When dividends (or assets) must be distributed, preferred stock holders get paid first (hence, the use of “preferred”). In other words, preferred stock is dependent on the company’s willingness and ability to pay dividends on its common stock. In addition, the preferred stockholder does not have any security in the company’s assets.
Qualified dividends are taxed at long-term capital gains tax rates (see above). If, however, the preferred stock is reported as debt (not equity) by the issuing corporation and the corporation takes a deduction when it distributes the dividends, then the dividends are actually interest, taxable to you as ordinary income.
Keep in mind also that a dividend can involve more than just a cash payment. A distribution of stock or stock rights on preferred stock can also be treated as a dividend.
Preferred stock also appreciates and depreciates in value. This can create capital gain or loss if the preferred stock is sold. The value of preferred stock will react to changes in the interest rate, market risk, and the company’s ability to pay dividends.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
The information provided is not intended to be a substitute for specific individualized tax planning or legal advice. We suggest that you consult with a qualified tax or legal professional.
LPL Financial Representatives offer access to Trust Services through The Private Trust Company N.A., an affiliate of LPL Financial.
This article was prepared by Broadridge.
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