Unwelcome dividend: Filing woes

Confusion over payouts means more amended 1099s

Mar 1, 2004 @ 12:01 am

By Frederick P. Gabriel Jr.

Financial advisers who prepare, or even review, their clients' tax filings can count on working overtime this tax season.

Last year's $350 billion tax cut package is causing widespread confusion over taxes on dividends from stocks and mutual funds. The uncertainty is so great that Charles Schwab & Co. Inc. is experiencing a giant 500% increase in the number of amended 1099 tax forms it is mailing to its customers.

"That's similar to what we've heard anecdotally from other firms," said Morrison Shafroth, a spokesman for the San Francisco-based discount broker. "It's an industrywide phenomenon."

Indeed, The Vanguard Group Inc. in Malvern, Pa., last week began mailing to some of its shareholders a "personalized qualified-dividend-income" statement. The form is intended to help them calculate how much of their dividend income qualifies for the lower tax rate under the Jobs and Growth Tax Relief Reconciliation Act of 2003.

Holding off

Because of the confusion, some financial advisers are telling clients to hold off filing tax forms until the brokerage firms and mutual fund companies finish sending out amended 1099s.

"I would never act on the first 1099 I get," said Joel P. Bruckenstein, president of Global Financial Advisors Inc. in Miramar, Fla. "The only way I would do it is if the client said, `Look, I've got to file the return early."'

Bill Baldwin, president of Pillar Financial Advisors Inc. in Waltham, Mass., also recommends that clients delay filing taxes.

"This isn't uncommon in the history of 1099s," he said of the high number of error-filled 1099s this year. "Anytime you get a 1099 from an intermediary, you probably shouldn't rush to file too early."

The change in tax law also means advisers have to pay more attention to their clients' holding periods on stocks or mutual funds. That is because even though a client's dividends qualify, they could lose the tax break if they fail to meet the holding period requirement.

The source of the confusion is the Jobs and Growth Tax Relief Reconciliation Act.

The law lowered to 15% the top tax rate on certain dividend income. Previously, all dividend income had been taxed at ordinary income rates of up to 38.6%.

But the reduced rate applies only to so-called qualified dividend income - that is, income from domestic corporations or foreign corporations that have tax treaties with the United States.

Many other kinds of income continue to be taxed at the higher rate, including interest from bonds, bond funds, money market funds or other fixed-income investments. Most dividends from preferred stock and real estate investment trusts will also be taxed at the higher rate.

If that isn't confusing enough, receipt of the tax break also depends upon how long an investor has held a fund or share.

In order to qualify for the lower tax rate, an investor has to have held the shares for at least 61 days during the 120-day period that begins 60 days before the "ex-dividend date" - the day on which a share no longer carries the right to receive the most recently declared dividend.

While the 1099 statement that shareholders get from fund companies or brokerage firms indicates whether a dividend qualifies for favored treatment, it doesn't show whether a shareholder is personally disqualified because they fail to meet the holding requirement.

For the most part, that will be up to shareholders - and their advisers - to figure out.

Another potential problem involves stocks held in margin accounts.

`Terrible headache'

Unbeknownst to many investors, brokerage firms often lend stocks in these accounts to other investors as part of a short sale. When that happens, the dividend is technically paid to the borrower, who then reimburses the investor in what is known as "payment in lieu of a dividend."

Under the old tax law, investors paid little attention to whether they received a dividend or a payment in lieu of a dividend, since both were subject to the same tax rate.

The new law, however, discriminates between the two by applying the lower tax rate to actual dividends. Payments in lieu of dividends are taxed at the higher rate.

"This is the first time in a long time that labeling something `dividend' actually makes a difference in terms of taxes," said Mark Luscombe, a federal tax analyst for CCH Inc., a tax publisher in Riverwoods, Ill. "The word `dividend' has been used pretty loosely in the past."

Ross Levin, president of Accredited Investors Inc. of Edina, Minn., which oversees about $345 million, said deciphering certain aspects of the law is a "terrible headache."

Two weeks ago, he sent letters to clients urging them to postpone filing their tax returns until after they have received amended 1099s. For those that have already filed, or chose not to wait, Mr. Levin is prepared to pick up the tab for filing an amended return.

Mr. Ross isn't the only one who may incur extra costs because of the tax law change.

Ameritrade Holding Corp. of Omaha, Neb., is reimbursing shareholders who received a payment in lieu of a dividend for any extra tax charges they incurred above what they would have paid if their income had been a bona fide dividend. Because of the way Ameritrade is calculating the reimbursement, investors who aren't in the top tax bracket may be reimbursed more than they are actually due.

"We don't want our clients to be hurt by this process," said Katrina Becker, a spokeswoman for Ameritrade.

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