Under federal tax law, stocks are capital assets.[1] When stocks are disposed of through a sale, taxes must be paid on gains realized from the sale. This is referred to as a capital gains tax.[2] Capital gains can be long-term or short-term, and these two types of capital gains are treated differently for tax purposes.
When securities are sold, the first step is to determine the cost basis. The cost basis must be subtracted from the sale price to determine the capital gain or loss.[3] Generally, the cost basis is the purchase price plus any costs associated with the purchase, such as commissions, recording and transfer fees.[4] If the owner was not the original purchaser of the shares, the cost basis is usually based on the previous owner’s adjusted basis of the stock or, in the case of property received from a deceased person, the value of the property on the date of the death of the transferor.[5]
Calculating capital gains requires that the seller be able to specifically identify the stocks that were sold. To obtain proof of cost basis, the seller must show written confirmation of the transaction and the price.[6] For publicly traded stocks, historical data from places like Yahoo! Finance may be used to show values on dates of acquisition or sale.
Where the purchased and sold stocks cannot be specifically identified because they were acquired at different times and/or at different prices, the cost basis can be determined by using the “first in first out,” or “FIFO” method. Under the FIFO method, the oldest shares are considered sold first. [7]
For example, assume Adam purchased 100 shares of XYZ Corporation on February 10 at a share price of $25 each. On August 11, he purchased an additional 200 shares of XYZ Corporation at $20 each. On November 1, Adam decides to sell 150 of his 300 XYZ shares.
To calculate the cost basis of the 150 shares using the FIFO method, he would add the purchase price of the 100 shares purchased in February, plus the purchase price of fifty of the shares purchased in August. The purchase price for 100 of the February shares was $2,500 and the purchase price for 50 of the August shares is $1,000. Therefore, Adam’s cost basis is $3,500.[8]
An alternative to the “FIFO” method is the “average basis” method. This method is typically used when determining the cost basis for mutual funds or similar financial products, where determining the bases of all the underlying stocks making up the product would be extremely complex. The method trades versatility for simplicity, as it takes the average basis of all shares in the product rather than allowing the holder the versatility to sell shares with different bases at different times.[9]
For example, assume Jane purchased 100 shares of ABC Mutual Fund on February 10, at $25 each. On August 11, she purchased an additional 200 shares at $20 each. On November 1, she sells 150 of the shares.
Unlike Adam in the previous example, if Jane is using the average basis method, she would first calculate the total purchase price of the 300 shares. In this case, the total purchase price of the 300 shares was $6,500. She would then divide the total purchase price by the total number of shares, or $6,500 divided by 300. The average basis is $21.67 per share. She would then multiply the average basis amount by 150. In this case, the basis of the 150 shares sold is $3,250.00.[10] A simple way to think about this would be to recognize that she sold half her shares and so her cost basis is half the total cost basis for all of her shares.
Tax Rates on Capital Gains
The capital gain or loss from a sale is the difference between the basis and the proceeds from the sale.[11] If this calculated number is positive, the seller has taxable capital gains. If the calculated number is negative, then the seller has a capital loss that can be used as a deduction.
Proceeds from selling stock are considered a form of income. “Short term” capital gains are taxed as ordinary income, while “long term” capital gains are taxed at a more favorable rate. A long-term capital gain is a gain on an investment that was held for more than one year, while a sale of something held for less than that is a short-term capital gain (or loss).[12]
Short term capital gains dividends are taxed at the ordinary income rates, which are staggered- based on income- into various brackets which max out at 37%.[13] Long term capital gains are taxed at more favorable rates that max out at only 20%. [14]
The 2017 Tax Cuts and Jobs Act changed the relationship between the long-term capital gains tax brackets and the ordinary income brackets. Under that law, long-term capital gains for taxpayers with under $38,600 of income are not taxed at all, while taxpayers who make over $425,800 are taxed at 20%. The in-between taxpayers (the vast majority) are taxed on long-term capital gains at 15%. These numbers are as of 2018 and generally increase incrementally and are also based on single taxpayers (married and head of household taxpayers have slightly different brackets).[15]
Net Investment Income Tax
In addition to the tax rates discussed above, taxpayers that meet certain income thresholds must pay an additional tax called the Net Investment Income Tax.[16] This is a 3.8% tax that must be paid on the lesser of:
(1) the taxpayer’s net investment income, such as capital gains and dividends, or
(2) the amount of the taxpayer’s modified adjusted gross income that is over the threshold income amount.[17]
A taxpayer’s modified adjusted gross income is a variant on the taxpayer’s adjusted gross income. Adjusted gross income is gross income less any applicable deductions. Modified adjusted gross income is adjusted gross income plus untaxed foreign income, non-taxable Social Security benefits and tax-exempt interest. For most tax payers, they are the same number.[18]
The net investment income tax applies only to taxpayers with high incomes, as the threshold amounts that trigger its application are:
– $250,000 for married filing jointly;
– $125,000 for married filing separately; and
– $200,000 for single filers and heads of households[19]
Dividends
Some stock owners receive portions of the issuer’s earnings and profits in the forms of dividends. Generally, dividends are paid in cash. However, dividends may also be paid in the form of stock in the same or another corporation or as other property.[20] Dividends are not considered capital gains.[21]
Dividends may be classified as ordinary dividends or as qualified dividends.
The most common type of distribution from a corporation or a mutual fund is an ordinary dividend.[22] Under the federal tax code, ordinary dividends are treated like any other type of ordinary income such as wages or salary.[23] Qualified dividends are taxed under the more favorable tax rates that apply to long-term capital gains.[24]
To be classified as qualified dividends, the dividend must have been paid by a U.S. corporation or a qualified foreign corporation and the taxpayer must have held the stock for the qualifying “holding period.”[25] This means that the taxpayer must have held the stock for at least sixty days during the 121-day period that begins sixty days before the ex-dividend date. The ex-dividend date is usually the day before the “record” date, which is the date on which one must have held the stock to be eligible to receive a dividend.
For example, assume John purchased 100 shares of ABC Company on July 5 and ABC Company paid a cash dividend of 10 cents per share. The ex-dividend date was July 12. John sold all 100 shares of ABC stock on August 8, 2017. John has no qualified shares because he held the stock for less than 61 days during the 121-day period. The 121-day period began on May 13, which is 60 days before the ex-dividend date and ended on September 10. When John sold his shares on August 8, he had only held his shares for 34 days of the 121-day period.[26]
The payer of the dividend, not the receiver, makes the determination of whether a dividend is qualified. Therefore, the IRS advises taxpayers to assume that any dividend received is an ordinary dividend unless stated otherwise by the entity paying the dividend.[27] The payor formally notifies the IRS and the taxpayer of the dividend’s status on the Form 1099-DIV sent to the taxpayer early in the year after the dividend was distributed. If the dividends are classified as ordinary dividends, this is notated in Box 1a on this form.[28]
For a corporation to be a “qualified foreign corporation” (and thus be eligible to issue qualified dividends), at least one of three conditions must be met:
(1) The corporation is incorporated in a U.S. possession,
(2) The corporation is eligible for the benefits of a comprehensive income tax treaty with the United States that the Department of Treasury finds acceptable, or
(3) The stock that the dividend was paid for is readily tradable on an established United States securities market.[29]
Examples of countries that have accepted income tax treaties with the United States include Australia, Italy, and Jamaica.[30]
Some dividends are excluded from being considered qualified. These include dividends paid on deposits with mutual savings banks, cooperative banks, credit unions and U.S. building and loan associations.[31]
When dividends are used to purchase more stock instead of being paid out as cash, such as pursuant to a dividend reinvestment plan or a mutual fund, the dividends must still be reported as income. Some dividend reinvestment plans allow the member to purchase shares at a rate lower than the fair market value. If that is the case, the purchaser must report the fair market value of the additional stock as dividend income.[32] For the timing purposes discussed in this module, the dividend date is when the proceeds were reinvested and the cost basis for the new shares is the amount of the dividend that was used to purchase the new shares.
Capital Losses
A capital loss occurs when property is disposed of at an amount that is less than the adjusted cost basis of the stock.[33] Capital losses can be used to offset capital gains from other sales in the same tax year. When the taxpayer’s capital losses for a year are more than her capital gains, she can take a capital loss deduction.[34] This deduction can decrease the amount of her adjusted gross income. Still, there are limitations to the deductibility of capital losses. As of 2019, the maximum deduction amount for capital losses is $3,000, or $1,500 if married but filing separately. If the capital loss amount is more than the maximum deduction, the unused portion can be carried over to the next tax year.
For example, assume John and Susan are married. They have a total income of $100,000 and they have a total net capital loss of $7,000. On their 2019 tax return, John and Susan can take a deduction of $3,000. They have remaining $4,000 in capital losses that can be carried over to the next tax year.[35]
Conclusion
Thank you for participating in LawShelf’s video-course on stocks and stock transfers. We hope that you now have a better understanding of what securities are, how they are traded and the regulations that apply to them. We encourage you to take advantage of our other courses in business law and securities. Please let us know if you have any questions or feedback.
[1] 26 U.S.C. § 1221(a)(1).
[2]Capital Gains and Losses, 10 Helpful Facts to Know, Internal Revenue Service, https://www.irs.gov/newsroom/capital-gains-and-losses-10-helpful-facts-to-know-0
[3]Cost Basis for Securities Transactions, U.S. SECURITIES AND EXCHANGE COMMISSION, https://www.sec.gov/fast-answers/answerscostbasishtm.html
[4] I.R.S. Pub. No. 551, Basis of Assets, Dec. 2018, https://www.irs.gov/publications/p551
[5] Id.
[6]See I.R.S. Pub. No. 550, Investment Income and Expenses IRS, pg. 42, (April 9, 2018) https://www.irs.gov/pub/irs-prior/p550–2017.pdf (“IRS Pub. 550 2017”).
[7] Id. at pg. 45.
[8] Id. at pg. 46.
[9] Average Cost Method, (Vanguard) available at https://investor.vanguard.com/taxes/cost-basis/average-cost
[10] IRS Pub. 550 2017 at 46 (numbers may vary).
[11] Capital Gains and Losses-10 Helpful Facts to Know, IRS, https://www.irs.gov/newsroom/capital-gains-and-losses-10-helpful-facts-to-know-0
[12] IRS Pub. 550 2017 at 54.
[13] Capital Gains Rates-How the Changes May Effect You, Maloney + Novotny, https://www.maloneynovotny.com/latest-news/capital-gains-rates-before-and-after-the-new-tax-law/
[14] Id.
[15] Matthew Frankel, Your Guide to Capital Gains Taxes in 2018, Dec. 22, 2017, (The Motley Fool) https://www.fool.com/taxes/2017/12/22/your-guide-to-capital-gains-taxes-in-2018.aspx
[16] IRS Pub. 550 2017 at 2-3.
[17] Id. at 3.
[18] Modified Adjusted Gross Income (MAGI), Healthcare.gov, https://www.healthcare.gov/glossary/modified-adjusted-gross-income-magi/
[19] IRS Pub. 550 2017 at 3.
[20] Topic Number 404- Dividends, IRS, https://www.irs.gov/taxtopics/tc404
[21] IRS Pub. 550 2017 at 19.
[22] Id.
[23] Topic Number 404- Dividends, IRS, https://www.irs.gov/taxtopics/tc404
[24] IRSPub. 550 2017 at 19.
[25] Id. at 20.
[26] Id.
[27] Id.
[28] Id.
[29] Id.
[30] Id.
[31] Id.
[32] Id.
[33] Id. at 68.
[34] Id.
[35] Id. 68-69.