Some Stocks In Margin Accounts Will Not See Tax Cut

by Mike Godfrey, Tax-News.com, Washington

10 June 2003

US investors are looking forward to receiving a bigger chunk of their dividends as President Bush's tax cuts begin to kick in over the coming weeks. However, those who hold stock in margin accounts may be in for a nasty surprise.

This is because many brokerages which run margin accounts lend out investors' stock to other entities such as hedge funds, which will often sell these stocks short. In the process, the borrower will pocket any dividends that accrue and reimburse the investor with a payment in lieu of a dividend. As technically, this can no longer be treated as a dividend for tax purposes, it could be liable for the higher rate of income tax at 35%, instead of the freshly cut rate for dividends of 15%.

This is a widespread practice in the brokerage industry, and the average investor usually won't even be aware of it. However, there is a danger that when it comes to tax filing day, investors will claim the lower tax rate, unaware that they have actually received payments in lieu of dividends. Congress has recognised this, and asked penalties to be waived in such cases.

Now the industry is having to look at changing the system, so that an investor can differentiate between a dividend and a payment in lieu. According to insiders, this will not be an easy task, and could take some time to implement.

Nevertheless, brokers will not want to discourage people from using margin accounts, and therefore it is imperative that they get the solution to this problem right. Charles Pomo, the head of the individual tax practice at Geller & Co., a New York accounting firm told Boston.com that brokers will be unlikely to land investors with a higher tax bill. "I don't think a brokerage firm will indiscriminately borrow from individual accounts and surprise them" he observed. "The only way to make it equitable is to compensate investors for it or look more to nontaxable accounts."

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