Annual Credit for Substitute Payments: Are you eligible?

You may be eligible for an annual credit adjustment if you received substitute payments in lieu of dividends. 

During a period in which shares would have earned dividends but were lent instead from your margin account, to help make up for the lost income you will receive substitute payments. 

With a tax rate as high as 37%, these substitute payments are taxed as regular income, unlike dividends. An annual credit is offered to help cover this additional expense. 

Qualifications for the annual credit

The annual credit has the following qualification to be considered eligible:

• You are a permanent resident or a U.S. citizen.
• An account registered as an individual, joint, estate, trust, or “pass-through” entity type (LLC, LLP, partnership, etc.), is where you received the substitute payment.  
• Had the security not been on loan, you would have reported the dividend as a qualified dividend. (If the applicable security is from a domestic or foreign corporation, you will be able to satisfy this requirement, and for the period required for qualified dividends, would have been held unhedged.)

Credit payments schedule

As soon as all reclassification information is available, or between March and May of the following calendar, credits are usually paid. Keep in mind that you have to make sure your account or a qualified substitute must be open to receive your credit. 

How is your credit calculated?

Approximately 26.98% of your total substitute payments are your credit generally. For example, your annual credit adjustment will be $26.98 if you received $100 in substitute payments for the entire year. 

This percentage is based on a number of factors. For instance, making further adjustments to account for any taxes the annual credit may incur after your substitute payment will be taxed at the highest federal tax rate (37%). 

Where can you find your credits and substitute payments on your return?

Annual credits are listed on line 3 and substitute payment on line 8 of Form 1099-MISC. 

It is recommended to list your credits as “other income” when filing your federal tax return. You can consult your tax advisor for additional help on how to report credits or substitute payments. 

In Lieu of Dividends, what is a Substitute Payment?

To generate portfolio income, many investors rely on dividends. Some of the money you received during the year might be shown on your year-end tax forms as a payment in lieu of dividends if you own stocks through a broker. This will be listed separately from your regular dividends. This could cost you more at tax time and can create tax hassle. Below are things on what you should know and what you do to avoid substitute payment. 

How does it work?

When your broker lent out the tax you own to short-sellers, it will result to substitute payments in lieu of dividends. Short sellers will sell your share that they borrow to an open market before returning the shares to you after the value goes down and they will repurchase it. 

The short sellers have to reimburse you for the lost dividend income if the stock pays a dividend during the period that they’ve borrowed the shares. Instead of receiving the payment from the company issuing the stock, you will receive reimbursement, and this is the substitute payment made in lieu of the dividends. 

The downside

Making the original shareholder whole is the whole point of payments in lieu. However, not qualifying for favorable tax rates on qualified dividends is the huge downside to payments in lieu. Depending on your tax bracket, qualified dividends have maximum rates of 0% to 20%. But despite that, at least 10 percentage points on the tax rate you pay on the dividends is saved. 

How can you prevent it?

Choosing a cash brokerage margin rather than a margin brokerage account is the best way to make sure you will never have to deal with substitute payments in lieu of dividends. To prevent the payment in lieu situation from coming about, your broker is not allowed to use your shares to lend to short-sellers in a cash account. In contrast, provisions allowing your broker to lend your shares whenever it wants is possible in a margin account. 

To ensure that you are getting the income you deserve, substitute payments in lieu of dividends are important. Nevertheless, the negative tax effect makes it something to be avoided.