Many publicly traded corporations offer dividend reinvestment plans (DRIPs). Shareholders can elect to reinvest their cash dividends in additional shares of the corporation’s stock, often at a discount. Are those shares taxable? It depends on how the plan is structured.
Rev. Rul. 78‑375, 1978‑2 C.B. 130, addresses two types of plans. First, a plan where shareholders can elect to have their cash dividends automatically reinvested in stock at a 5% discount. The IRS held that this plan triggered § 305(b)(1) – the shareholders had an election to receive stock or cash, so the stock was taxable as a dividend. The amount of the dividend was the fair market value of the stock received (including the discount).
Second, the plan also allowed shareholders to make additional optional cash purchases of stock at a 5% discount. This triggered § 305(b)(2) – some shareholders received property (the cash dividends they didn’t reinvest) while others (those making optional purchases) increased their proportionate interests. The amount of the dividend was the discount – the difference between the fair market value of the stock and the optional payment.
What if the plan simply reinvests dividends by purchasing shares on the open market, without the corporation issuing new shares? In Rev. Rul. 77‑149, 1977‑1 C.B. 82, the IRS held that there was no § 305(b)(1) issue because the shareholders didn’t have an election to receive stock from the corporation – they simply received cash and then instructed an agent to buy shares. The cash dividend was taxable under § 301, and the subsequent purchase was a separate transaction.
The key takeaway: If you’re designing a DRIP, be careful about giving shareholders an election to receive stock or cash. That election triggers immediate dividend taxation. A plan that uses an agent to buy shares on the open market avoids this issue.
This article is for general informational purposes only and is subject to change. Tax laws are complex and vary by situation. You should consult a qualified professional for advice specific to your circumstances. For questions, contact Alan Goldstein.
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