General

• Stock represents an ownership interest in a business entity. In order to encourage individuals to make long-term capital investments in businesses, the Internal Revenue Code has long allowed special, reduced tax rates for investors who meet certain holding-period requirements before selling a company's stock. Dividends are periodic payments made by businesses (specifically corporations) to their shareholders. With the Jobs and Growth Tax Relief Reconciliation Act of 2003, Congress extended the special, reduced rates on capital investments in stocks to dividends.
  
  

Capital Gains

• Stocks are classified by the Internal Revenue Service (IRS) as capital assets. All capital assets held for more than one year are classified as long-term. All capital assets sold after a holding period of a year or less are short-term. Profits resulting from the sale of long-term capital assets are currently taxed at a maximum marginal tax rate of 15 percent, significantly below the top marginal tax rates for ordinary income. For low-income taxpayers, gains on the sale of long-term capital assets may be taxed at rates as low as 0 percent.
  
  

Deferral of Income

• Gain from the capital appreciation of stock is deferred until the stock has been transferred or sold or the risk associated with owning the asset has been removed. This deferral of tax allows for the value of stock to appreciate, untaxed, over a period of many years. In addition, it allows the investor to manage the sale of the stock into tax periods where the investor pays lower tax rates, such as retirement
  
  

Warning

• The IRS has several rules to prevent abuse of the preferential tax treatment of stock. First, capital gains must be used to first offset capital losses before capital losses may be used to offset ordinary income. Secondly, "wash sale" rules prevent the deductibility of losses on a sale and immediate repurchase of an asset. This would otherwise be done simply to recognize tax losses. Finally, the IRS limits the deductibility of capital losses against ordinary income to $3,000 in a given tax year.
  
  

Dividends

• The 2003 Jobs and Growth Tax Relief Reconciliation Act established a reduced tax rate for qualified dividends from stocks. These dividends had previously been taxed at ordinary income rates and were now eligible for taxation at the reduced long-term capital gains rates. The holding period for stock dividends to qualify for qualified treatment is significantly less than that required for long-term capital gain treatment, typically 61 days prior to the ex-dividend date, or the date when stockholders are determined for dividend payment purposes.