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Tax Tips: Dividend and interest income

This is the third in a six-part series. In each article, you'll find advice from an experienced CPA on how to work the tax code to your advantage to trim your tax bill come April 17.

Did your investments do well in 2005? If so, congratulations! But now the time has come to pay the piper (read IRS). There are taxes to be paid on those earnings.

However, there's good news on that front. You can still reap the benefits of the Jobs and Growth Tax Relief Reconciliation Act of 2003, which lowered the long-term capital gains rate to 15 percent on investments you've held for more than one year (it's 5 percent for taxpayers in the lowest tax brackets). We describe other beneficial changes below.

The basics

Dividends are another form of earnings. You can receive them from a corporation as a stockholder, or passed through from a partnership, an estate, or a trust. Most corporations use Form 1099-DIV to report dividends. Dividends from a partnership are reported on Schedule K-1 (Form 1065), while dividends from a subchapter S corporation are reported on Schedule K-1 (Form 1120S). You must include all these on your tax return and pay tax on them all.

This is where additional good news comes in. The 2003 law also made a distinction between ordinary dividends, which are taxed as ordinary income, and "qualified dividends," which are taxed at the same favorable rates as long-term capital gains. In order to get the favorable lower rate, you must have held the stock on which you receive the dividend for at least 60 days.

So how do you tell which kind of dividend income you have? On Form 1099-DIV, ordinary dividends will be shown in box 1a, and qualified dividends in box 1b. On Schedule K-1 (Form 1065), ordinary dividends are on line 6a and qualified dividends on line 6b. On Schedule K-1 (Form 1120S), ordinary dividends are on line 5a and qualified dividends on line 5b. If you're a shareholder in an S corporation or C corporation for your practice, dividends or distributions from these corporations are not qualified. However, if the corporation holds onto investments that produce qualified dividends, they can be passed along to the shareholders.

What about earnings from other investments?

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