7938 / What are ordinary income dividends from a mutual fund? How are ordinary income dividends received from a mutual fund taxed?

Ordinary income dividends. Ordinary income dividends are derived from the mutual fund’s net investment income (i.e., interest and dividends on its holdings) and short-term capital gains. A shareholder generally includes ordinary income dividends in income for the year in which they are received by reporting them as “dividend income” on his or her income tax return.¹

However, under JGTRRA 2003, qualified dividend income (see Q 702) is treated in some respects like net capital gain and is, therefore, eligible for what are now the 20/15/0 percent tax rates instead of the higher ordinary income tax rates. (ATRA 2012 made the special treatment of “qualified dividends” permanent—or as permanent as anything in the IRC.) As a result of JGTRRA 2003, mutual funds are required to report on Form 1099-DIV the nature of the ordinary dividend being distributed to shareholders—that is, whether the ordinary dividend is a “qualified dividend” subject to the 20/15/0 percent rates (Box 1b), or a nonqualifying dividend subject to ordinary income tax rates (Box 1a). Unless otherwise designated by the mutual fund, all distributions to shareholders are to be treated as ordinary income dividends.

Ordinary income dividends paid by mutual funds are eligible for the 20/15/0 percent rate if the income being passed from the fund to shareholders is qualified dividend income in the hands of the fund and not short-term capital gains or interest from bonds (both of which continue to be taxed at ordinary income tax rates).²

The Service has stated that mutual funds that pass through dividend income to their shareholders must meet the holding period test (see Q 702) for the dividend-paying stocks that they pay out to be reported as qualified dividends on Form 1099-DIV. Investors must also meet the holding period test relative to the shares they hold directly, from which they received the qualified dividends that were reported to them.³ In summary, the holding period test (see Q 702) must be satisfied by both the mutual fund and the shareholder in order for the dividend to be eligible for the 20/15/0 percent rate.⁴

The Service has ruled that in making dividend designations (under IRC Sections 852(b)(3)(C), 852(b)(5)(A), 854(b)(1), 854(b)(2), 871(k)(1)(C), and 871(k)(2)(C)), a mutual fund may designate the maximum amount permitted under each provision even if the aggregate of all the amounts so designated exceeds the total amount of the mutual fund’s dividend distributions. (IRC Section 852(b)(3) provides rules for determining the amount distributed by a mutual fund to its shareholders that may be treated by the shareholders as a capital gain dividend (see Q 7940).) IRC Section 854 provides rules for determining the amount distributed that may be treated as qualified dividend income. IRC Section 871(k) provides rules for determining the amount distributed that may be treated as interest-related dividends or short-term capital gain dividends). The Service further ruled that individual U.S. shareholders may apply designations to the dividends they receive from the mutual fund that differ from designations applied by shareholders who are nonresident alien individuals.⁵

Varying distributions paid by a mutual fund to shareholders in different “qualified groups” (shares in the same portfolio of securities that have different arrangements for shareholder services or the distribution of shares, or based on investment performance) constitute deductible dividends for the mutual fund.⁶

An award of points to a shareholder under an airline awards program, in which one point is awarded for each new dollar invested in the mutual fund, will not result in the payment of a preferential dividend by the fund; instead, the investor will be informed of the fair market value of the points and informed that the basis in the shares giving rise to the award of points should be adjusted downward by the fair market value of the points as a purchase price adjustment.⁷

Editor’s Note: All miscellaneous itemized deductions subject to the 2 percent floor were suspended for 2018-2025 and eliminated entirely under the 2025 OBBB.

Certain pass-through entities are required to report as part of a shareholder’s ordinary income dividends the shareholder’s allocated share of certain investment expenses (i.e., those which would be classified as miscellaneous itemized deductions if incurred by an individual), in addition to ordinary income dividends actually paid to a shareholder. The shareholder then must include such additional amount in income and treat the amount as a miscellaneous itemized deduction (subject to the 2 percent floor) in the same year. However, publicly offered regulated investment companies (generally mutual funds) are excluded from the application of this provision.⁸

See Q 7944 regarding dividends declared for a year prior to the year of receipt. See Q 7977 for the treatment of certain stock distributions by mutual funds.