Investors With Margin Accounts Could Suffer Under Tax Law

NEW YORK (Dow Jones)--Investors who own stock in a margin account may be in for an unpleasant surprise: the dividends they receive may not be eligible for the new, lower tax rate.

That's because brokerages often lend stock held in these accounts to other investors, such as hedge funds, that make bearish bets. This has no impact on an investor's ability to sell stocks in their accounts. But such an investor doesn't receive the dividends paid on stocks that are loaned out. These go to the borrower, who then reimburses the investor an amount of money equal to the dividend.

In the past, investors were largely indifferent to whether they received a dividend or what's called a "payment in lieu of a dividend," since both were subject to the same tax rate. Indeed, brokerages don't distinguish between the two in account statements or on tax forms, so investors generally aren't even aware when their stock is lent out.

But the tax package signed into law last month discriminates between dividends, which are taxed at a maximum rate of 15%, and payments in lieu of dividends, which are taxed at ordinary income rates of up to 35%.

Since the dividend tax cut is retroactive to Jan. 1, investors who thought they received dividends earlier this year, and expect to be subject to the lower tax rate, may actually be subject to the higher rate if their stock was on loan when the dividend was paid.

The distinction is only relevant to investors with margin accounts, which allow them to purchase stock with money borrowed from the brokerage. Brokerages generally don't lend stock held by customers in ordinary accounts.

The Securities Industry Association, Wall Street's trade group, has published a brochure to help member firms educate clients about the impact of the tax package. Available on the group's Web site at www.sia.com, it includes a section on the treatment of payments made in lieu of dividends. "This is a complicated concept to understand, but an important one," the brochure says. It urges investors to talk to their financial consultants for more details.

Tax experts say investors probably don't need to worry about their 2003 returns. It's up to the Treasury Department to publish rules interpreting the tax package, but Congress has asked that the penalty be waived for investors who claim the lower tax rate this year when they unknowingly received a payment in lieu of a dividend.

In the meantime, brokerages will have to put new systems in place to tell clients whether they have received dividends or payments in lieu of a dividend. SIA spokesman Dan Michaelis said he didn't know how long this would take, but it's "going to involve some effort."

However, one industry observer noted that brokerage firms already have systems in place to notify corporate clients when stock held in their accounts is lent out over a dividend-record date. Adapting the systems to notify individual investors might not take more than a few weeks, this person said.

Brokerages that don't want to discourage clients from investing on margin will have to decide whether to stop lending out stock in these accounts, at least over dividend record dates, or come up with some way to compensate clients who incur a higher tax rate on payments made in lieu of dividends.

"I don't think a brokerage firm will indiscriminately borrow from individual accounts and surprise them" with a bigger tax bill, said Charles Pomo, the head of the individual tax practice at Geller & Co., a New York accounting firm. "The only way to make it equitable is to compensate investors for it or look more to nontaxable accounts" for stock loans, he said.

Michaelis, the SIA spokesman, said he doesn't know which approach members will take. "This raises a lot of questions," he said.

Some brokerages lend out more stock to short sellers than others, so an investor's chance of receiving a payment in lieu of a dividend, rather than a dividend, depends on where he or she has a margin account.

For example, Edward Jones, a regional broker-dealer based in St. Louis, has about $2 billion in margin loans to customers outstanding, but less than $10 million of stock held in these accounts loaned to short sellers, according Jeff Orf, manager of settlement and trades.

Firms that cater to short sellers, including Goldman Sachs Group Inc. (GS), Bear Stearns Cos. (BSC), Morgan Stanley (MWD) and Merrill Lynch & Co. (MER), had no immediate comment.

However, a source at one major securities firm said less than 10% of stock loaned out to short sellers comes from margin accounts of taxable investors. The rest is loaned from the portfolios of institutional investors such as pension funds that are tax-exempt.

-By Allison Bisbey Colter, Dow Jones Newswires; allison.bisbey-colter@dowjones.com; 201-938-5298

-By Cheryl Winokur Munk, Dow Jones Newswires; cheryl.munk@dowjones.com; 201-938-2123

Just when you thought it was safe to margin again.

I've also yet to see an analysis of how AMT affects the new tax changes.

I've also yet to see an analysis of how AMT affects the new tax changes.

You just reminded me that I’m going to have to scratch out a couple of checks in the next week or so.

There’s going to be a few happy people to see the dividend tax decrease. I know several retirees that have 100,000 - 250,000 or more shares of company stock and they’re getting ~$0.20/share every quarter. That’s a nice little shot of cash to have in addition to whatever pension they get.

A lot of that will end up getting blown in Vegas or some other tourist-type place. I’m not sure how much that benefits the overall economy, but I’ve seen them spread it around pretty thick in places like that.

Just why wouldn't the owner of stock receive dividends? the short seller who borrows the stock from the broker pays the dividend and the brokers clears it all, so where do they come up with this wacky assertion? Hell, this has NEVER happened to me, in either a segregated or non-segregated account.

They will more likely be seeing the value of the portfolio rise more than the dividend tax benefits and have to contend with paying a lower cap gains tax on a greater cap gain.Bummer :-)

The way I understood it is that the short seller borrows the stock and then sells it. The buyer then receives the dividends. But now 2 people own the same stock: the original owner from whom the shares were borrowed and the buyer who bought shares from the short seller. To make the original owner whole with respect to dividends, the short seller makes a cash payment to the original owner. The issue is that under the new law these cash payments will not receive the same favorable tax treatment as dividends.

The easy solution is to simply charge the Short seller an additional fee to cover the higher taxes, in exchange for being allowed to borrow the stock to sell short in the first place.

Oh no, Short selling just became more costly! < /MOCKING! >

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