Tax Treatment of Dividends Under the 2003 Tax Cut: Fact Sheet

CRS Report for Congress
Received through the CRS W eb
Tax T reatment of Dividends Under t he 2003
Tax Cut: F act Sheet
Senior Specialist i n Economic Policy
Government and Finance Division
W h ile ordinary and p referred s tock dividends, along with some foreign dividends,
are eligible for dividend relief i n t he form of a l ower tax rat es , certain dividends are not
el i gi b l e. D i v i d ends ret ai n t h ei r o ri gi nal charact er i f recei ved i ndi rect l y t h rough m ut ual
funds and real estate investment trusts and are el i g ible. Dividends which are already
el i gi b l e for t ax preferences and h el d i n p ensi ons or IR As are not el i gi b l e. T hi s fact sheet
will not be updated.
The J obs and Growth T ax Relief R econciliation Act of 2003 (H.R. 2 , P .L. 108-027)
reduces the i ndividual i ncome t ax rate on cer tain dividends and o n capital gains to 15%
from 2002 through 2008 (5% t hrough 2007 and 0 % t hrough 2008 for i ndividuals in the
t wo l ower t ax b racket s). T he purpos e o f t hi s fact sheet i s t o ex pl ai n what t yp es of
dividends, i n addition t o o rdinary d ividends on common s tock received d i r e c t l y by
individuals, are eligible for t he lower rat e.
Eligible Divi dends
Ordinary dividends, d ividends on prefe rred s tock, and dividends fr o m q u alified
foreign corporations are eligible. S tock must have been held at least 6 0 d ays out of the
120-day p eriod b eginning 60 days before the ex d ividend d ay. 1 Qualified foreign
corporations include those t raded o n U.S. m arkets and t hose t hat d o not trade but whose
income tax t reatment falls under a treaty with the U.S. t hat p rovides for an ex change of
information, with ex ceptions listed bel ow.
Di vi dends t h at a r e recei ved t hrough regul at ed i nvest m ent com p ani es (R IC s ),
commonly referred t o as m utual funds, are eligible for t he lower rate. Note, however, t hat

1 T he ex dividend day is the day the stock trades without an announced divi dend and i s norma lly
two business days before t he record day ( the date when t he company determi nes who owns the
stock) to account for s ettleme nt lags . A person who buys t he stock t he day before t he ex divi dend
day will receive the dividend, while a person who buys t he stock on t he ex divi dend day will not.
Congressional Research Service ˜ The Library of Congress

paym ents labeled as d ividends of these funds do not always arise from d ividend i ncome,
but may reflect earnings o f i nterest b earing assets. Only t he amounts reflecting d ividend
income are eli gi b l e for the beneficial t reatment (unless 95% or more of earnings arise
from dividends). A s imilar rule applies t o real es tate investment tru s t s (REITs). Since
mutual funds have a large share of dividends, a significant fraction of earnings from
mutual funds will be eligible. M ost i ncome o f R EITs will not be.
Divi dends Not E ligible
Di vi dends i n al ready t ax preferred ret i rem ent and annuity plans, including paym ents
from IRAs, 401(k) plans, and t hrift p lans are not eligible. C learly, d ividends from R oth
IR As are not el i gi b l e si nce t hey are current l y ex em pt from t ax . H owever, o t h er pensi o n
and t hrift p lans have the equivalent of ex emption b ecause, although p ayouts are subject
to tax , contributions are d eductible. The deduction o f t he contribution o ffsets t he present
value of future t ax es . C ertain plans, al so not eligible for t he lower dividend t ax rate, have
a benefit that defers rather than effectivel y ex empts from t ax ; t hat i s t hey do not allow
deductibility of contributions, but tax es o n ret urns are d eferred until received as annuity
paym ents (at which time a portion representing ret urn o f principal is ex em pt).
Investments t ax ed in this fashion i nclude fix ed and variable annuities and non-deductible
traditional IRAs.
Dividends of tax ex empt entities or e n t ities for which dividend deductions are
avai l abl e are not el i gi b l e. T hese i n cl ude di v i d e n d s recei ved from t ax ex em pt
organizations in general (thes e organizations are listed i n s ection 501 o f the Internal
Revenue Code and i nclude pension t rusts m entioned above), tax e x e m p t farmers’
cooperatives, m utual s avings banks that r eceive a d ividend d eduction under s ection 591
of the IRC, and dividends deductible by firms on employer s ecurities (i.e. em ployee stock
ownership p lans).
Dividends of forei gn c o rporations not traded on U.S. securities m arkets and not
eligible for t he benefits (for s ubstantially al l i ncome) of a t reat y with the U . S . t h at
provides appropriate information s haring are i neligible. The current U.S.-Barbados treaty
is specified as not appropriate for t his purpose until the Treas ury promulgat es regulations.
In addition, dividends from foreign investment companies, foreign p assive inves t m e nt
companies, and foreign personal hol ding companies will not be eligible.
Paym ents in lieu of dividends are not eligible. These are payments associ at ed with
short s ales (borrowing stock t o s ell and red eem i n g i t l at er) w hi ch are m ade t o t he l ender.
However, there i s a recognition t hat s ecurities brokers and deal ers m ay not eas ily be able
to identify t hese paym ents in lieu of t ax es. Dividends that are asso ci at ed with an
obligation t o m ake a rel at ed paym ent on a similar position are not eligible. The tax payer
may not elect the p referential rate for divi dends used t o o f f s e t investment interest