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Need-to-Know Tax Planning for Stock Investing

Need-to-Know Tax Planning for Stock Investing

August 01, 2023

What is investment tax planning for stocks?

Investment tax planning for stocks takes advantage of the tax rules with the goal of achieving the best after-tax return on these investments. Strategies will differ depending on whether you purchase common stock or preferred stock.

What is common stock, and how does it generate earnings?

Common stock is a form of equity that represents a share of ownership in a corporation. The shareholders of a corporation own the business and therefore benefit from its earnings, which can be distributed as dividends. If the business grows in value, shareholders can capitalize on this growth by selling their shares. Of course, shareholders also bear the risk that the business will decrease in value.

Essentially, there are four ways in which earnings on common stock may be realized:

  • Cash dividends
  • Capital gains (profit from the sale of your shares of common stock)
  • Stock dividends
  • Distributions of property

Cash dividends

In general

Many corporations distribute periodic cash payments on their common stock. These payments are referred to as dividends. A dividend is a distribution out of a corporation's current or accumulated earnings and profits. Why is this important? Corporations are taxed twice, once when the corporation earns income (at corporate income tax rates) and again when those earnings are distributed to shareholders as a dividend.

Qualifying dividends received by an individual shareholder from a domestic corporation or qualified foreign corporation are taxable at long-term capital gains tax rates. The reduced rates apply to both the regular tax and the alternative minimum tax.

Long-term capital gains and qualified dividends are generally taxed at special capital gains tax rates of 0 percent, 15 percent, and 20 percent depending on your taxable income. The actual process of calculating tax on long-term capital gains and qualified dividends is extremely complicated and depends on the amount of your net capital gains and qualified dividends and your taxable income.

This change in the law is advantageous to most investors who receive qualified dividends. Currently, a taxpayer in the highest marginal tax rate (37 percent) will be taxed on qualified dividends at a rate of 20 percent. That's a 17 percent savings.

However, not all corporate distributions are entitled to tax-reduced dividend treatment.

Dividend capital gain tax treatment exceptions and rules

Qualified dividends (eligible for capital gains tax treatment) are those that are received from domestic corporations and qualified foreign corporations. Corporate stock dividends passed through to investors by a mutual fund or other regulated investment company, partnership, real estate investment trust, or held by a common trust fund are also eligible. In addition, amounts received upon disposition of stock received as a nontaxable stock dividend that would otherwise be subject to ordinary income rules (i.e., IRC Section 306 stock) may qualify.

Tip: A qualified foreign corporation is one that is traded on an established U.S. securities market or is incorporated in a U.S. possession. A foreign corporation may also qualify if a comprehensive income tax treaty including a satisfactory exchange of information program exists between the United States and the corporation's country. Countries that specifically do not qualify include Barbados, Bermuda, Cayman Islands, Costa Rica, Dominica, Dominican Republic, Grenada, Guyana, Honduras, Jamaica, Marshall Islands, Peru, Saint Lucia, Trinidad, and Tobago.

Dividends that are ineligible for capital gains tax treatment include payments that are typically called dividends but are actually interest. Interest received from savings accounts, certificates of deposit, corporate bonds, and U.S. Treasury securities is ineligible for the lower rates. Investors will pay taxes on this interest as ordinary income. Income from a tax-deferred vehicle, such as a 401(k) plan, IRA, or an annuity, is also ineligible even if the funds represent dividends from corporate stock held within the vehicle. The lower rates also do not apply to dividends paid by the following:

  • Credit unions
  • Mutual insurance companies
  • Tax-exempt organizations
  • Farmers' cooperatives
  • Nonprofit voluntary employee benefit associations (VEBAs)
  • Employer securities owned by an employee stock option plan (ESOP)
  • Any mutual savings bank, savings and loan, domestic building and loan, cooperative bank, or other type of bank eligible for the dividends paid deduction under IRC Section 591.
  • Stock owned for less than 61 days during the 121-day period beginning 60 days before the ex-dividend date
  • Stock purchased with borrowed funds if the dividend was included in investment income in claiming an interest deduction
  • Stock with respect to which related payments must be made to substantially similar or related property
  • Substitute payments in lieu of a dividend made with respect to stock on loan in a short sale

Further, dividends from preferred stock that is reported as debt and pays interest that is deducted by the corporation are not eligible.

Capital gains

Profit or loss from the sale of common stock is treated as capital gain or loss. Long-term capital gains benefit from preferential tax rates. To determine the applicable capital gains tax rate, you must distinguish between shares of stock held for different periods of time. Stocks held for one year or less generate short-term capital gains, which are taxed at the ordinary income tax rates. Stocks held over one year generate long-term capital gains that are generally taxed at special capital gains tax rates of 0 percent, 15 percent, and 20 percent depending on your taxable income.

Clearly, controlling the time (holding period) you own a share of stock and limiting income in a given year can result in tax savings. These and other timing strategies are discussed below.

Determining profit from the sale of common stock: basis rules

Capital gain or loss from the sale of stock is determined by the difference between the amount realized and the tax basis. For most people, this means the difference between the amount you paid for the stock and the price at which you sell the stock. However, there are certain occasions when you must use special rules to determine your tax basis. These include the following:

  • Stock received as a gift or inheritance — Your starting basis when you receive shares as a gift is the tax basis of the The starting basis for stock received as an inheritance is generally the fair market value at the death of the donor.
  • Stock splits and dividends — A stock split involves a division of your stock into more units of the same In theory, the aggregate value of the old and new shares should be the same. Your basis in stock that undergoes a split or in stock that pays a stock dividend must be spread among the resulting shares.

Example(s): Assume Corporation X declares a 2-for-1 stock split. You own 100 shares that you purchased two years ago at $5 per share and that currently are worth $10 per share (or $1,000). After the stock split, you own 200 shares worth $5 per share (or

$1,000). There is no gain on receipt of the additional shares.

A stock dividend, like a stock split, is a proportionate distribution of stock to all the shareholders. It essentially subdivides the stock.

Example(s): Assume Corporation X declares a proportionate 10 percent stock dividend. You own 100 shares that you purchased two years ago at $5 per share and that currently are worth $10 per share (or $1,000) before the split. After the stock split, you own 110 shares. These are worth approximately $9.10 per share (or $1,000). There is no gain on the distribution.

Your gain or loss on a subsequent sale is the difference between your cost basis and the sale price. How do you determine basis in your shares? Further, what is the holding period for these shares when there is a stock split or stock dividend? You must allocate the basis of the old shares between the old shares and the new shares. If you purchased several blocks of stock at different times, you must allocate the basis proportionately. In the first example, the $500 basis is allocated among the 200 shares. Thus, the basis per share is $2.50. In the second example, the $500 basis is allocated among the 110 shares. Thus, the basis per share is approximately $4.55 per share. The holding period is the same as for the old stock. If you purchased several blocks of stock at different times, you must allocate the holding period proportionately. In the above examples, the holding period is two years for all the stock.

  • Nontaxable cash distributions (return of capital) — On occasion, you may receive a cash distribution on common stock that is not from the corporation's current or accumulated earnings and profits. Generally, such distributions are not treated as taxable dividends. This distribution returns some or all of the initial investment to the shareholders and may occur when a corporation has suffered losses for a series of years but still continues to pay out a consistent dividend. These distributions are not taxed if they do not exceed your stock's tax basis (i.e., the amount you paid plus any subsequent adjustments). To the extent that such distributions exceed basis, you must realize capital gain. Return of capital distributions result in a corresponding downward adjustment to basis.

Tip: If you are contemplating the purchase of a stock that has suffered consistent losses, you should have a sound investment reason for the purchase. In the short term, however, if the corporation continues to make cash distributions to shareholders, this may provide an opportunity for you to realize some of your investment return on a tax-free basis.

  • Partial sales of stock holdings — The general capital gain rules require you to use either (1) the specific identification method, or (2) the first in, first out (FIFO) rule to determine the basis of common stock in partial sales. The specific identification method lets you pick and choose which securities to sell (assuming you can identify them). The FIFO method requires you to treat the first share purchased as the first sold. This is beneficial from the standpoint of a shareholder who desires to have any gains on sales of the shares characterized as long-term capital gains, but it may have negative consequences in terms

of tax basis if the market is rising in value.

Distributions of property

From time to time, a corporation may distribute property to its shareholders. As discussed above, you are generally not taxed on the distribution of a stock dividend issued on the corporation's own shares. However, a distribution may be taxed if it is one of the following:

  • A distribution offering a choice between stock or cash
  • A distribution that disproportionately affects shareholder interests
  • A distribution of convertible preferred stock
  • A distribution of common and preferred stock
  • A preferred stock dividend (see below)

Distributions in complete liquidation of a corporation are taxable events. There are special rules for distributions in partial liquidation of a corporation and for certain corporate reorganizations. These distributions may be wholly or partially tax free. Distributions of other property owned by the corporation will usually result in gain but not loss. As a general rule, if the distribution is taxed, the basis of the distributed property is its fair market value. If the distribution is tax free, your basis will depend on specific tax rules.

Tip: Potential distributions of property may offer you the opportunity to defer or accelerate gain or loss, depending on the nature of the transaction. Likewise, purchasing or selling stock in anticipation of special distributions (depending on your personal situation) may provide you with tax advantages.

Are there any other special tax rules for common stock?

There are a number of other special tax rules for common stock. These include the following:

Short sales

When you sell a stock short, you effectively borrow the stock from your broker and sell it in the hope that the price will decrease. You then purchase stock at the lower price, using these shares to repay your broker. If you purchase at a lower price, you have a gain. This is treated as short-term capital gain subject to ordinary income tax rates. If you purchase at a higher price, you generally have a short-term capital loss. A number of special tax rules apply to short sales.

Margin trading

Margin trading involves borrowing money from your broker in order to purchase a security. Interest charged on a margin account is deductible, but only when the interest is paid. The account is not unitary. Thus, you cannot report net gains and losses but must relate account items to each transaction.

Investment expenses

Commissions, fees, and charges paid to acquire or sell shares of common stock are not deductible. Rather, these costs are added to tax basis. This either decreases your capital gain or increases your capital loss. These expenses generally cannot be used to offset ordinary income.

What are some tax planning strategies involving common stock?

There are a number of tax planning considerations concerning common stock. These include the following:

Timing transactions, including year-end planning

For tax reasons, you should time your purchases and sales of common stocks much like you would with any other investment. Depending on your circumstances, you may seek to incur or avoid ordinary income or capital gain. As a general rule, you should prefer long-term capital gain to ordinary income because the rates are lower. However, if you have excess ordinary losses for a given year, you may very well want to incur dividend income. This underscores the importance of year-end planning. At the end of your tax year, you have the best idea of the amounts of your annual income, gains, and losses. You can then engage in a variety of transactions that will provide tax benefits. Of course, you can anticipate year-end results and execute a given sale or purchase at any time during the current year.

What are some planning opportunities with stocks? The timing of a stock sale controls all of the following:

  • Whether you will have long- or short-term capital gain
  • The tax rate on your long-term capital gain
  • Whether a distribution that you receive will be treated as an ordinary dividend taxable at ordinary income tax rates or a qualified dividend taxable at long-term capital gains tax rates
  • Whether you will receive a tax-free return of capital
  • Whether you will receive a special distribution and thus incur ordinary income, capital gain, or even a capital loss

Investment selection

Remember that your goal is to achieve the best after tax return on your holdings in common stock. Since the tax rates vary depending on the type of asset you own, how long you own it, and the type of income or gain you receive, your after-tax rate of return will also vary depending on these factors.

Investment selection relating to common stock centers on these factors. First, compare the growth and dividends of one common stock to another. Second, compare various types of common stocks to other investments such as bonds or mutual funds. Your time horizon, loss potential, and income tax bracket may increase or decrease the tax rate.

What is investment tax planning for preferred stock?

Investment tax planning for preferred stock takes advantage of the tax rules to achieve the best after-tax return on these investments. In some ways, preferred stock is like a loan. Generally, this type of stock is entitled to a preset or fixed dividend that is much more like interest than like a true dividend. However, the payment is usually financed out of earnings. When dividends (or assets) must be distributed, preferred stock holders get paid first (hence, the use of "preferred"). In other words, preferred stock is dependent on the company's willingness and ability to pay dividends on its common stock. In addition, the preferred stockholder does not have any security in the company's assets.

Taxation of preferred stock: dividends

Qualified dividends are taxed at long-term capital gains tax rates (see above). If, however, the preferred stock is reported as debt (not equity) by the issuing corporation and the corporation takes a deduction when it distributes the dividends, then the dividends are actually interest, taxable to you as ordinary income.

Keep in mind also that a dividend can involve more than just a cash payment. A distribution of stock or stock rights on preferred stock can also be treated as a dividend.

Taxation of preferred stock: sale or exchange

Preferred stock also appreciates and depreciates in value. This can create capital gain or loss if the preferred stock is sold. The value of preferred stock will react to changes in the interest rate, market risk, and the company's ability to pay dividends.

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

The information provided is not intended to be a substitute for specific individualized tax planning or legal advice. We suggest that you consult with a qualified tax or legal professional.

LPL Financial Representatives offer access to Trust Services through The Private Trust Company N.A., an affiliate of LPL Financial.

This article was prepared by Broadridge.

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