Tax Consequences on Penny Stocks

by Leslie McClintock

Penny stocks -- so called because of their extremely low share prices -- are historically extremely volatile investments. The potential for gain is high, but so is the potential for loss, since penny stocks tend to be less-established companies. From a tax standpoint, however, penny stocks are generally treated the same way as C-corporations. They are still subject to double taxation: once at the corporate level and then again on the shareholder's individual income tax return.

Capital Gains

When you invest in a stock and later sell those same shares for a profit, you will have a capital gains tax liability on the difference between the sale price and your tax basis in the stock. Your tax basis is simply the total money you have invested in the property or stock.

Dividend Income

Because penny stocks are usually earlier-stage companies without a lot of cash reserves, they tend to reinvest their earnings back into the company rather than issue dividends to shareholders. When they do issue a dividend to shareholders, however, that amount is normally taxable. Dividends from qualified U.S. corporations are taxed at a lower rate than ordinary income tax, at least through 2012. As of 2011, the maximum tax rate for dividends from qualified U.S. corporations is 15 percent -- and it is zero for those in the 15-percent marginal income tax bracket or lower.

Double Taxation

As of 2011, all C-corporations must pay a 35-percent income tax to the U.S. government. What's more, they must pay the tax prior to issuing dividends. Dividends are not tax deductible to the corporation. This means that when the dividends reach the individual shareholder, they have already been taxed. Nevertheless, the individual shareholder must pay the income tax on dividends received, except in tax-advantaged retirement accounts.

Retirement Accounts

Assets held in retirement accounts, such as IRAs, Roth IRAs and 401(k)s, are exempt from taxes on dividend income or on capital gains. Instead, Roth IRA plans and Roth-designated accounts in 401(k)s grow tax free, and distributions are tax free, provided the funds have been in the Roth accounts for at least five years. For 401(k) plans and traditional IRAs, distributions in retirement are taxable as ordinary income.

Special Rules for Day Traders

If you are a pattern day trader, you are subject to special tax rules. You report any trading expenses or other business expenses related to your trading activity on Schedule C, "Profit or Loss From Business." Commissions are not tax deductible for traders, but you can figure your trading costs into your cost basis for capital-gains tax purposes. For more information, see IRS Publication 550, "Investment Income and Expenses."

Mark-to-Market Accounting

If you are a day trader, you must decide whether to elect to use mark-to-market accounting. If you make this election, you must report sales on IRS Form 4797, Part II, "Sales of Business Property." If you do not elect mark-to-market treatment, you report gains and losses on Schedule D of your individual tax return.

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