Shareholders who own common or preferred stock in companies that offer a dividend reinvestment plan can elect to have their dividends applied toward additional share purchases rather than receive cash. To encourage investor participation, some companies also allow dividend reinvestments at a discount to the current share price, also known as fair market value. Both the dividend and discount amounts are taxable.
Companies mail a Form 1099-DIV in January to all stockholders who received dividends during the previous year. This applies whether the dividends were paid in cash or allocated to a dividend reinvestment plan. Some DRIPs add a small service charge, and those amounts can be deducted on Form 1040 if the sum of all miscellaneous deductions exceeds the standard deduction.
Fair Market Value
The amount of reinvested dividends may not represent a stockholder's only dividend tax liability. Investors often seek companies that offer a discount to their stock's fair market value (FMV) on reinvested dividends to maximize their returns. This amount, which typically ranges from several percentage points to 10 percent, is based on the closing stock price on the dividend's payment date.
Investors report all reinvested dividends and any applicable discounts on Schedule B of IRS Form 1040. Shareholders must own their stocks for a couple of months to receive the favorable tax rate on dividends, which is capped at 15 percent. According to the IRS, an investor "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." Day traders and others who time their purchases and sales just to capture the dividend are taxed at the regular income rate.
Shareholders who choose to sell their holdings of one or more dividend-paying stocks during the course of the year report their gains or losses on Schedule D of Form 1040. They often time those decisions to sell after the record date of the current quarterly dividend, but as with any stock holding, trying to time the market can end up costing more than the extra dividend amount received.