Tax implications | Equity | Investment vehicle characteristics

Investors only have two ways to make a return on stock - dividends and capital gains. Therefore, stock taxation relates to these two forms of return. It’s essential to understand how these taxes apply and potential tax obligations assessed by the Internal Revenue Service (IRS).

Dividends

A cash dividend is income received from common or preferred stock. Investors also receive dividends from funds (e.g., mutual funds) that pass through income received from investments in their portfolio. Dividends are generally taxed at lower rates, but here are the specifics:

Qualified dividends:

Taxable at 15% for most investors
Taxable at 20% for investors at the highest income tax brackets

Non-qualified dividends:

Taxable up to 37% (based on income tax bracket)

Dividends can be qualified or non-qualified, which relates to how they’re taxed. Dividends are qualified if the issuer meets specific qualifications and the investment is held for a certain amount of time (don’t worry about the specifics). The majority of dividends received by investors are qualified.

Qualified dividends are taxed at 15% for most people, while those at the two highest income tax brackets pay 20%. The amount of reported income factors into an individual’s marginal tax bracket (discussed below). The more income made, the higher the tax bracket. Only a small portion of taxpayers fall into the highest income tax brackets.

One of the only instances you’ll need to be aware of non-qualified dividends is with real estate investment trusts (REITs) (discussed later in these materials). With a higher tax rate on the income received, REITs must offer higher rates of returns to encourage investors to purchase their units. Non-qualified dividends are taxable up to 37%, depending on the investor’s tax bracket.

Sidenote

Progressive vs regressive taxes

Currently, the United States enforces a progressive tax system with income taxes; those with higher levels of income pay a higher percentage of taxes on their income. While you don’t need to know the specifics, the lowest federal income tax bracket is 10% (for those with low reported income), while the highest income tax bracket is 37% (for those with high reported income).

Estate and gift taxes are also progressive. An estate refers to assets owned by a deceased person, which eventually are distributed to heirs and beneficiaries. The federal government only taxes estates valued above $13.61 million, while taxes are only due on gifts valued above $18,000. Those with less money involved pay less or no taxes in a progressive tax system.

A regressive tax system is a flat taxing system, regardless of income levels or amount of money involved. Sales tax is an example of a regressive tax. Whether you’re a billionaire or have no reported income, you pay the same percent tax on the items you buy at the store. Excise tax, a tax on a specific good (like cigarette taxes), is also regressive.

Corporate investors obtain even more tax benefits than individual investors. Known as the corporate dividend exclusion rule, corporate investors avoid paying taxes on large portions of dividends they receive. In particular:

Corporations can avoid paying taxes on:

50% of dividends if owning less than 20% of the issuer’s common stock
65% of dividends if owning 20% or more of the issuer’s common stock

Corporations typically maintain brokerage accounts to invest unneeded cash. When this occurs, corporations end up owning portions of other companies. For example, let’s assume General Electric (GE) owns a small portion of Coca-Cola (KO) stock. If Coca-Cola makes a dividend payment of $100,000 to GE, GE will only pay taxes on $50,000. If GE owned 20% or more of Coca-Cola, they would only pay taxes on $35,000 of the $100,000 dividend payment (65% exclusion).

Dividends are reported annually on the tax form 1099-DIV. Brokerage firms send these forms to their customers and the IRS. The form details the amount of dividends received and the status (qualified or non-qualified). For a dividend to show up on a given year’s 1099-DIV form, it must be paid in that year. If a dividend were declared in 2023 but was paid in 2024, it would be reported on 2024’s 1099-DIV form.

Capital gains & losses

A capital gain is realized when a customer sells a security at a higher price than its original cost. If you’ve heard anyone say, “buy low, sell high,” they’re talking about capital gains. Otherwise, selling a security below its cost is a capital loss. A gain or loss is realized upon a position being closed out (long securities sold or short securities bought back). Investors compare their cost basis to sales proceeds to determine the overall gain or loss.

Cost basis represents the overall amount paid to buy the security, including any commission. Sales proceeds represents the overall amount received to sell a security, minus commission. In basic terms, cost basis represents the overall amount paid for an investment, while sales proceeds represent the overall amount received for selling it. To better understand this concept, let’s work through an example:

An investor purchases shares of ABC stock at $50 while paying a $2 per share commission. Several months later, the stock is sold for $70 while paying another $2 per share commission. What is the cost basis, sales proceeds, and capital gain or loss?

Can you figure it out?

(spoiler)

Cost basis = $52

The cost basis is equal to the cost of the investment ($50) plus commission ($2), which represents the overall amount paid to purchase the investment.

Sales proceeds = $68

Sales proceeds are equal to the sale price of the investment ($70) minus commission ($2), which represents the overall amount received to sell the investment.

The capital gain or loss = $16 capital gain

Subtracting cost basis from the sales proceeds ($68 - $52) determines the overall gain or loss. If it’s a positive number, it’s a capital gain. If it’s a negative number, it’s a capital loss.

Capital gains can be long or short-term. Long-term capital gains are made on securities held for longer than a year. Technically, an investor must hold an investment for one year and a day to obtain long-term status. Long-term capital gains are taxed similarly to qualified dividends - 0%, 15%, or 20%, depending on their annual income level.

Short-term capital gains are made on securities held for one year or less. Short-term capital gains are taxed at the investor’s income tax bracket, which could be as high as 37% (similar to non-qualified dividends). Obviously, investors prefer long-term capital gains because they’re taxed at lower rates.

Capital gains are reported on form 1099-B (B stands for brokerage proceeds). Every year, brokerage firms report their customers’ capital gains and losses to the IRS. If the investor has more gains than losses (net capital gain), they will owe taxes. A net capital loss can be used as a deduction.

Sidenote

Selling specific shares

When investors sell shares accumulated over several trades, deciding what shares to sell becomes an important objective. Let’s assume an investor dollar cost averages these purchases over the course of three years:

Year	Purchase amount	Price per share	Shares purchased
2020	$10,000	$20	500
2021	$10,000	$25	400
2022	$10,000	$16	625

Unless otherwise specified, shares are sold on a first-in, first-out (FIFO) basis as a default, meaning the oldest shares are sold first. Let’s assume the investor sells 800 of their 1,525 shares at $30 per share and uses this method. In this example, they would be selling:

500 shares purchased at $20/share
300 shares purchased at $25/share

Next, the investor can find their overall cost basis by adding up the numbers. They bought 500 shares for $10,000 in 2020 and 300 shares for $7,500 (300 shares x $25 per share) in 2021. The total cost of the 800 shares (500 + 300) was $17,500 ($10,000 + $7,500). This adds up to an average cost basis of:

800 shares purchased at $21.88 ($17,500 / 800 shares)

When the investor sells those shares at $30 per share, they lock in an overall $8.12 per share gain ($30.00 sales proceeds - $21.88 cost basis).

The investor could also opt to sell shares on a last-in, first-out (LIFO) basis, which would sell the newest shares first. Again, let’s assume the investor sells 800 shares at $30 per share and find the overall gain using this method:

625 shares purchased at $16/share
175 shares purchased at $25/share

Let’s find their average cost basis. They bought 625 shares for $10,000 in 2022 and 175 shares for $4,375 (175 shares x $25 per share) in 2021. The total cost of the 800 shares (625 + 175) was $14,375 ($10,000 + $4,375). This adds up to an average cost basis of:

800 shares purchased at $17.97 ($14,375 / 800 shares)

When the investor sells those shares at $30 per share, they lock in an overall $12.03 per share gain ($30.00 sales proceeds - $17.97 cost basis).

Last, the investor can also utilize a method called specific share identification, where the investor specifically identifies which shares to sell. To minimize taxes as much as possible, the investor will first sell the most expensive shares. Using this method, they’ll sell:

400 shares purchased at $25/share
400 shares purchased at $20/share

Let’s find their average cost basis. They bought 400 shares for $10,000 in 2021 and 400 shares for $8,000 (400 shares x $20 per share) in 2020. The total cost of the 800 shares (400 + 400) was $18,000 ($10,000 + $8,000). This adds up to an average cost basis of:

800 shares purchased at $22.50 ($18,000 / 800 shares)

When the investor sells those shares at $30 per share, they lock in an overall $7.50 per share gain ($30.00 sales proceeds - $22.50 cost basis). Let’s compare all of the numbers now:

Method	Gain per share
FIFO	$8.12
LIFO	$12.03
Specific share	$7.50

Of the three methods, specific share identification was the most tax efficient. Remember, the lower the reported gain, the less taxes the investor pays. Specific shares identification always allows investors to reduce their tax liability to the lowest possible level.

Key points

Cash dividends

Taxable income received from common or preferred stock
Tax rates:
- Qualified = 15% or 20%
- Non-qualified = up to 37%
Reported on tax form 1099-DIV

Progressive tax systems

Higher taxes if more money involved
Examples:
- Income taxes
- Estate taxes
- Gift taxes

Regressive tax systems

Flat tax rates
Examples:
- Sales taxes
- Excise taxes

Corporate dividend exclusion rule

Corporations avoid paying taxes on dividends
50% exemption if owning less than 20% issuer’s common stock
65% exemption if owning 20% or more of the issuer’s common stock

Capital gain

Securities sold for more than the basis
Reported on tax form 1099-B

Share selection methods for sales

FIFO
LIFO
Specific share identification
- Is the best method to reduce taxation

Capital loss

Securities sold for less than the basis
Reported on tax form 1099-B

Long-term capital gain

Gain on security held more than 1 year
Tax rate: 15% or 20%

Short-term capital gain

Gain on security held for 1 year or less
Tax rate: up to 37% (income tax bracket)