Ordinary vs. Qualified Dividends

Dividends represent a distribution of corporate profits to shareholders. For tax purposes, dividends are classified as either ordinary dividends or qualified dividends, with the classification determining whether preferential tax rates apply. This distinction can result in tax savings of up to 17 percentage points (37% ordinary rate vs. 20% qualified rate).

The Basic Distinction

Key insight: All qualified dividends start as ordinary dividends. A dividend must first meet the definition of an ordinary dividend, then satisfy additional requirements to receive qualified treatment.

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Ordinary Dividends

Ordinary dividends are the most common type of dividend distribution from a corporation or mutual fund. They are reported in Box 1a of Form 1099-DIV and taxed at the taxpayer's regular federal income tax rate.

What Qualifies as an Ordinary Dividend?

Ordinary dividends include:

• Cash dividends paid by corporations
• Dividends from money market funds
• Mutual fund distributions of interest income
• Short-term capital gain distributions from mutual funds
• Certain dividends from REITs (Real Estate Investment Trusts)
• Dividends from tax-exempt organizations

2024 Ordinary Income Tax Rates

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Qualified Dividends

Qualified dividends receive preferential tax treatment at long-term capital gains rates. They are reported in Box 1b of Form 1099-DIV and represent a subset of Box 1a (total ordinary dividends).

Requirements for Qualified Dividend Status

For a dividend to be qualified, three conditions must be met:

1. Paid by a U.S. corporation or qualified foreign corporation
2. Holding period requirement satisfied
3. Not specifically excluded by the tax code

2024 Qualified Dividend Tax Rates

Tax savings example: A single taxpayer in the 35% bracket with $10,000 in dividends would owe $3,500 if ordinary, but only $1,500 if qualified (15% rate)—a savings of $2,000.

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Holding Period Requirements

The holding period is one of the most frequently tested dividend concepts on the EA exam. Understanding these rules precisely is essential.

The 60-Day/121-Day Rule (Common Stock)

To qualify for preferential rates, you must hold the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date.

Counting rules:

• Count starts the day after you acquire the stock
• The day of sale counts toward the holding period
• You must hold for more than 60 days (61+ days)

Example: Stock goes ex-dividend on March 15. The 121-day period runs from January 14 through May 14. You must hold the stock for more than 60 days within this window to receive qualified treatment.

Special Rule for Preferred Stock

For preferred dividends attributable to periods totaling more than 366 days, stricter rules apply:

• Must hold for more than 90 days
• During a 181-day period beginning 90 days before the ex-dividend date

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Dividends That Are NOT Qualified

Even if holding periods are met, certain dividends never qualify for preferential rates:

Always Taxed as Ordinary Dividends

Foreign Corporations: When Do They Qualify?

Foreign corporation dividends can be qualified if the corporation is:

• Incorporated in a U.S. possession
• Eligible for benefits under a U.S. income tax treaty
• Traded on an established U.S. securities market (ADRs often qualify)

IRS maintains a list of treaty countries whose corporations can pay qualified dividends. Common qualifying countries include the UK, Canada, Australia, Germany, France, and Japan.

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Net Investment Income Tax (NIIT)

High-income taxpayers may owe an additional 3.8% tax on investment income, including dividends. This is in addition to regular income tax or capital gains rates.

2024 NIIT Thresholds

Important: These thresholds are not adjusted for inflation—they have remained unchanged since 2013.

Maximum Effective Rate on Dividends

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Form 1099-DIV: Key Boxes Explained

Form 1099-DIV reports dividend and distribution income from investments. Understanding each box is crucial for proper reporting.

Essential Boxes for the EA Exam

Reporting on Form 1040

• Box 1a (Total ordinary dividends): Report on Form 1040, Line 3b
• Box 1b (Qualified dividends): Report on Form 1040, Line 3a
• Schedule B required if total ordinary dividends exceed $1,500

Understanding the Box 1a/1b Relationship

Box 1b is a subset of Box 1a—it represents the portion of total ordinary dividends that qualifies for preferential rates. If a taxpayer has:

• $2,000 in Box 1a (total ordinary dividends)
• $1,500 in Box 1b (qualified dividends)

Then $1,500 is taxed at qualified dividend rates (0%, 15%, or 20%), and the remaining $500 is taxed at ordinary income rates.

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Box 3: Nondividend Distributions (Return of Capital)

Box 3 reports return of capital distributions—these are not taxable income. Instead, they reduce your cost basis in the stock.

Tax Treatment of Return of Capital

1. First, reduce your basis: Subtract Box 3 amount from your cost basis
2. If basis reaches zero: Any additional distributions are taxable as capital gain
3. Higher gain at sale: Lower basis means more gain when you eventually sell

Example: You own stock with a $10,000 basis. Over several years, you receive $3,000 in Box 3 distributions. Your new basis is $7,000. If you later sell for $12,000, your gain is $5,000 (not $2,000).

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Key Exam Concepts

Comparison Summary

Common Exam Traps

1. Box 1b is included in Box 1a - Don't add them together; Box 1b is a subset
2. REIT dividends are usually ordinary - Not qualified despite preferential treatment under Section 199A
3. Holding period must be met for EACH dividend - Not just one annual requirement
4. Foreign dividends can qualify - If from treaty country or traded on U.S. exchange
5. NIIT thresholds are fixed - They don't adjust for inflation

Exam Tip: When a question asks about dividend taxation, first determine if the dividend is qualified (check source and holding period), then apply the correct rate based on the taxpayer's income level.