The Internal Revenue Service (IRS) defines dividends as distributions of property. For stocks, dividends are most often in the form of a cash payment. Many companies offer stockholders the option of reinvesting dividends to purchase additional shares of stock instead of receiving a cash payment. As far as the IRS is concerned, however, a dividend is a dividend and is taxable income.
For many companies, dividends are the preferred method of sharing profits with stockholders. When you sign up for a dividend reinvestment plan, you agree to accept dividends in the form of additional shares. The number of shares you receive depends on the fair market value of the stock on the date the dividend is distributed. For example, if the stock is trading at $50 per share and you would have received $1,000 as a cash dividend, that amount is reinvested to pay for 20 additional shares.
Dividend income is considered earned income, not capital gains. This is the case whether you are paid the dividend in cash or choose to reinvest the money. For reinvested dividends, you have to report the fair market value of the shares you receive on the day they are issued to you. Reinvested dividends are taxed as ordinary income at your marginal tax rate (the highest tax rate any of your income is subject to).
Unlike cash dividends, reinvested dividends change the cost basis of the stock you own in a company. Cost basis, or tax basis, is your total investment amount. For example, if you paid $10,000 for 200 shares plus a $100 in broker’s commissions and other fees, your cost basis is $10,100. If you reinvest dividends worth $1,000 for an additional 20 shares, you end up with a cost basis of $11,100 and a total of 220 shares.
Using a dividend reinvestment program to add to the shares you hold in a company has a couple of advantages. You purchase additional shares on a regular basis. In addition, many companies issue the additional shares with no additional fees. This eliminates broker's commissions and other transaction costs. Keep track of the shares you are issued, their value and the dates for tax purposes.