A nasty surprise on dividends

Advisers, investors may be caught unawares by tax rule change

Jan 12, 2004 @ 12:01 am

By Brooke Southall

A dividend tax rule change may catch some investors and advisers by surprise. The new rule may also put the interests of broker-dealers, stockbrokers and their clients in conflict with one another, according to accountants and analysts.

If investors hold stocks in margin accounts, and the broker-dealer lends those shares, the dividends go to the institution or person who borrowed them. The investor receives an in-lieu payment that is equal to the actual dividend payment.

As of Jan. 1, the Internal Revenue Service treats this reimbursement as ordinary income, which means that the investor no longer enjoys the 15% rate charged on dividends. Many investors pay as much as 35% on ordinary income.

The new rule also extends to dividends paid on stocks against which an investor is borrowing. In addition, investors will pay taxes at ordinary income rates on dividends from stocks with collars or on which they have sold a call or bought a put.

"It's a huge issue, and I think there's a lot of investors who simply don't know," said Timothy P. Speiss, a partner in charge of the financial planning practice at KPMG LLP in New York.

"I think it's going to be much more obvious when the 1099 dividend forms arrive," he said. "In 30 days to six weeks, people are going to say, `What do you mean?"'

Mr. Speiss said he thinks that both financial advisers and individuals are unaware of the new rule. He finds himself delivering the news when he gives speeches to groups of both these constituencies.

Robert Gordon, president of New York-based broker-dealer Twenty-First Securities Corp., said he has talked to tax directors at virtually all the major Wall Street brokers, which are trying to let clients know about the rule change.

"All the firms believe they made all the disclosures or are about to make the proper disclosures," he said.

"They're not keeping this under the radar screen," Mr. Gordon added. "They're aware, concerned, and they're doing whatever necess

ary to let people know and to make this right."

But Stephen Winks, a principal with SrConsultant.com of Richmond, Va., said that if financial advisers and investors are in the dark on this issue, the brokerage industry's disclosures don't necessarily mean much.

"If the industry isn't dealing with it in a way that people truly understand, then these firms would be conflicted in giving up a significant revenue source versus a negative tax implication to a client," he said.

Debate over concern

Mr. Gordon allows that Wall Street brokers are stopping short of shouting warnings from the rooftops.

"They may not be going out of their way," he conceded. "But the tax directors [at these firms] are very, very concerned."

But Derek Jaskulski, strategic analyst with Portland (Maine) Global Advisors LLC, thinks that financial firms aren't concerned enough. Mr. Jaskulski, whose firm has $60 million under management, said he thinks the conflicts run deeper than people realize.

For instance, he said, in communications to clients from Fidelity Investments of Boston and Lehman Brothers Inc. of New York, the tax information is relayed in cursory and legalistic language.

"I think it's a little disingenuous [of those firms] not to say, `You could move your assets to a cash account to avoid this,"' Mr. Jaskulski said.

"They present the problem but not the solution," he said. "It's a sin of omission."

Mr. Jaskulski first became aware of the gravity of the conflict when a stockbroker he knows moved all his client assets to cash accounts from margin accounts because of the rule change.

The broker believed he had a fiduciary duty to make the asset transfers, Mr. Jaskulski said. The broker's managers disagreed, and they read him the riot act.

The underlying problem, Mr. Jaskulski added, is that hedge funds and other short-sellers have a voracious appetite to borrow securities from Wall Street, and the wirehouses are only too happy to oblige.

He and M

r. Winks, both of whom used to work for broker-dealers, say that as much as 45% of the profits at some of these firms come from margin-related business.

Fidelity's tough stance

What is particularly unsettling, Mr. Jaskulski said, is that clients end up in margin accounts by default, especially considering that they don't share in the profits made from the loans.

"I think you should explicitly agree to lend your securities," he said.

Still, Mr. Gordon said that in his experience, broker-dealers are careful to borrow securities primarily from 401(k) and other accounts where taxes aren't of consequence.

But Mr. Winks said investors shouldn't take comfort in that claim. "That's a bunch of bunk," he said.

Mr. Gordon added that three tax directors at other brokerage firms told him they would go so far as to reimburse clients for any extra taxes they would have to pay because of the rule change.

However, he isn't certain whether this would happen automatically at those firms or only upon the customer's request.

In its disclosure, Fidelity makes it clear that clients shouldn't expect any such payments.

"You are not entitled to any compensation in connection with securities lent from your account or for additional taxes you may be required to pay as a result of any tax treatment differential between substitute payments and actual interest," the Fidelity disclosure states.

Compensation aside, Mr. Jaskulski said he has always been loath to give brokers permission to lend his securities.

"Why should I agree to lend to someone who wants to drive the value of what I own down?" he asked.

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