A lot of companies that are publicly-traded in the stock market have dividend reinvestment plans (DRIPs), whereby investors in the company’s stock agree to reinvest their dividends by purchasing more of the same stock, rather than receiving cash disbursements. DRIPs are fairly common when you invest in mutual funds. Tax treatment for stock sales with dividend reinvestment will differ slightly, depending on the specific features of the particular company’s DRIP.
Types of DRIPs
Some dividend reinvestment plans require you to pay a periodic service charge for participation privileges. The service charge may be deducted from the dividend you receive, in which case you must report the deducted service charge to the IRS, as dividend income. Some companies may pay the broker commissions on stock purchases made through the plan, or they may deduct the commission costs from your dividend, reducing the number of shares you receive. Some companies maintaining a dividend reinvestment plan invest your dividends directly into company stock, while others invest in stock on the open market. Your company’s DRIP may permit you to make optional purchases of additional stock shares, through a cash payment sent to the trustee of the plan.
Reporting Dividend Income
The IRS requires you to treat automatically reinvested dividends as dividend income, if the dividends are used to purchase more stock for a price equal to its fair market value. If your company’s DRIP allows you to purchase additional stock shares for less than its fair market value, you report the fair market value of the new stock as dividend income on the dividend payment date. A number of dividend reinvestment plans permit you to use cash to buy additional company stock for a price below its fair market value. In this case, the IRS requires you to report the difference between the cash amount you invested and the fair market value of the additional stock shares, as dividend income. You must use the value of the shares as of the dividend payment date.
How you are taxed on stock sales with dividend reinvestments is determined by your initial basis (cost less expenses) in the shares you buy through a company’s DRIP. Your initial basis in the stock is the amount you paid for the shares (fair market value), plus any amount taxed as a dividend (taxable distribution), minus any service charges deducted from your dividend. The initial basis determines the amount of your taxable dividend income. The dividend income tax can range from 0 to 15 percent on qualified dividends (eligible for capital gains tax) or 10 to 35 percent for ordinary dividends, depending on your income bracket.
The IRS also takes into account whether your gain (if any) on the stock sale was long-term or short-term. If the dividend reinvestment plan, issues you a dividend on June 15, your holding period begins on June 16 If you sell your shares on or prior to June 15 of the following year, your gain is short-term and your regular income tax rate will apply. If however, you hold the shares for more than a year before selling, your gain is long-term and you are taxed at the lower capital gains rate.