Most common stock in the United States are shares of C Corporations. This means that these corporations are taxed on net income. Additionally, any dividends paid out to shareholders are taxed at the personal level leading to the term double taxation. Fortunately for dividend growth investors, long-term holders of stocks usually benefit from qualified dividends which are taxed at the long-term capital gains rate (usually 15-18.8%). The IRS outlines the qualifications for a qualified dividend:
- be paid after December 31, 2002
- be paid by a U.S. corporation, by a corporation incorporated in a U.S. possession, by a foreign corporation located in a country that is eligible for benefits under a U.S. tax treaty that meets certain criteria, or on a foreign corporation’s stock that can be readily traded on an established U.S. stock market (e.g., an American Depositary Receipt or ADR), and
- meet holding period requirements: You must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. The ex-dividend date is the first date following the declaration of a dividend on which the buyer of a stock is not entitled to receive the next dividend payment. For calculation purposes, the number of days of ownership includes the day of disposition but not the day of acquisition.
It pays to be long term holder of high quality dividend growing stocks as you benefit from improved tax rates!
There are however other corporate structures that pay out dividends or distributions. Real Estate Investment Trusts are a special corporate structure that allows the company to not pay out taxes as long as 90% of net income is distributed to shareholders. Often REITs will pay out more than their net income due to high amounts of depreciation and interest. Most REIT distributions don’t benefit from qualified status due to the 90% distribution requirement. However, if there is no net income to distribute then REIT pays out of its retained capital account and the distribution is considered a return of capital. Return of Capital is untaxed!
The same goes for Master Limited Partnerships. There is an additional layer of tax complexity because MLP unit holders are taxed as partnerships and require Form K-1s to be distributed for each unit holder. This can be an advantage for MLPs though as they have similar depreciation and amortization profiles as REITs meaning many of the distributions are Return of Capital.
These rules could have a significant impact on how you evaluate your investments and the income they generate. Net of taxes there could be as much as a 20% hit to your income by investing in a REIT or MLP vs shares in a common stock. This means when evaluating yields, it may be more beneficial to purchase a common stock with a lower yield than a REIT or MLP. A 4.5% yielding common stock in this case would provide better net income than a 5% yielding REIT due to tax status. While you may individually have a different tax situation, it is possible to make generalizations about the impact based on the average profile of distributions or dividends. So it is a roughly safe bet to discount REIT yields by 15-20% to account for additional taxes.