Tax implications

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 than income from other courses; 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.

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 on the tax form 1099-DIV annually. 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 2022 but was paid in 2023, it would be reported on 2023’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?

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.