Payments received from a corporation are typically considered dividends. These are taxed at ordinary income rates. The Internal Revenue Service reasons that since they are paid from the earnings and profits of a corporation, they are ordinary income to you, the recipient.

Corporations are required to provide you with a year-end tax form that states the amount of dividends that corporation paid to you in the previous tax year. These statements must be retained by you and the amounts reported must be reported on your tax return.

Normally, the reporting of these dividends is straightforward, since either your investment broker, or the corporation whose stock you own is required to report the dividends to you. All you are usually required to do is to report the correct amount on your taxes and to keep the forms as your records in the event of an audit. However, one area presents a problem for many taxpayers in today's investment-minded taxpayers.

Use Discretion Regarding Income in a Dividend Reinvestment Plan

What about when dividends are used to buy more stock from the same company? These plans are typically called Dividend Reinvestment Plans. The income paid to you in the form of dividends is reportable as ordinary income in most cases, even if you are enrolled in the dividend reinvestment plan, and never really get to see or use the money.

Another pitfall is that a purchase of stock in a dividend reinvestment plan at a price below the FMV [Fair Market Value] of the stock must also be reported as ordinary dividend income on a taxpayer's tax return. However, the Internal Revenue Code allows you to deduct any service charges assessed by the corporation for such plans.

A problem encountered with Dividend Reinvestment Plans is keeping track of the price of each of the shares of stock purchased for you. The only time this amount is reported to you is at the time the shares are purchased, often quarterly. The statement from the Plan Administrator is usually the only report or document you have that the shares were purchased at a particular price.

Conflicts:

Assume that you hold a stock for 10 years. Each quarter the dividend amount, which can vary in some years, enabled you, under the dividend reinvestment plan, to purchase several additional shares of stock in lieu of paying the dividend in cash. Assume that in the first quarter of Year One, the Plan enabled you to purchase 10 shares at $50 each. In the second quarter of Year One, the plan purchased 9 shares at $55. In the fourth quarter of Year One, the dividend enabled you to purchase 7 shares of stock at $65 per share. This continues for 10 years. When you sell the stock, what is your basis and how do you prove it?

The Dividend Reinvestment Plan Administrator will not usually perform this function for you. You are required to under the law. Thus, if you did not have all the statements for 10 years, you would have to reconstruct each quarter's history to determine the basis of the stock at the time of the purchase. This can be a monumental task.

Reporting Dividend Income on Your Return

One quirk here is that you cannot use Form 1040 EZ if you have any dividend income. Also, when you receive dividend income, you can use either Form 1040 or Form 1040A, but in both instances you are required to attach a Schedule to the form if your ordinary dividends total more than $400.

Deducting Expenses Related to Dividend Income

The Internal Revenue Code allows for a deduction of some of the expenses related to dividend income, but only when you are itemizing your deductions. Be sure to document the nature of these expenses, as they will likely be challenged in an audit.