305(c) Dividends: All of the Tax, None of the Cash

Learn what a 305(c) deemed dividend is and what it means in practical terms for your tax return.

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5 min read

Like most people, you are likely ready to close the book on this tax season, right? You are already imagining how good the finish line will feel. And just as you are about to submit your return, you’ve noticed something on your 1099 form that you were not expecting. This possibly unpleasant surprise is income that is reported as a dividend. However, you didn’t receive cash for it; and you don’t see it on any of your monthly statements. But, since its on your tax form, you are definitely going to be taxed on it. It’s possible that what you’re seeing represents a deemed dividend, per IRC 305(c).

What is a 305(c) Deemed Dividend?

The technical definition is that a 305(c) deemed dividend is the value of additional shares resulting from the Conversion Rate Adjustment, or CRA, on a convertible debt security. Under Section 305(c) of the Internal Revenue Code, the change in the conversion ratio or price is treated "as a distribution by the corporation with respect to any shareholder whose proportionate interest in the earnings and profits or assets of the corporation is increased by such change."  Whew, that was a mouthful.

A Conversion Rate Adjustment (CRA) can occur on a convertible debt security when a distribution is paid on the underlying stock, and folks owning the debt instrument will receive an increased number of shares at conversion.

Now that we know the technical definition, what does that mean in practical terms? This situation could apply if you hold a bond that can be converted to a stock (or the underlying security) that pays a dividend. The value of that dividend event is calculated and reported as a deemed dividend, even though you have not actually received any cash and may not currently even own the shares that pay the dividend. This also applies to warrants that can be converted to stock.

How Deemed Dividend is Calculated

You may be wondering how the amount of the deemed dividend is determined? The calculation for this can be complicated, but it basically seeks to capture the value of the right to acquire the shares of the underlying stock. To determine the amount reported on your 1099, take the number of shares of the convertible security held on ex-div date (or entitlement date) and multiply it by a rate supplied by the company itself or calculated by vendors based on marketplace data.

Say you hold 100 shares of a warrant, and the underlying stock that the warrant can be converted to pays a dividend. The entitlement date is 2/18/18, and the rate is .1642. To calculate the deemed dividend amount, take the 100 shares of the warrant times the .1642 rate. This equals the $16.42 deemed dividend.

Strange as it may seem, this is reportable to the IRS by your broker, and you could be taxed on it. Uncle Sam’s rationale for this reporting is that you’re getting the benefit of additional shares if the conversion rate is changed. You also get the benefit of a proportionate interest increase in the earnings and profits of the company. The IRS wants its share of that, so brokers are required to report it.

What about Taxability?

305(c) deemed dividends are reported on form 1099-DIV as ordinary or qualified dividends. TD Ameritrade clients will see an end note (that little number 60 to the far right) which will direct you to the last page of the 1099 with additional details to help you easily identify these dividends.

FIGURE 1: 1099-DIV REPORTING.

The last dividend reported refers to an end note, which will explain that this distribution is considered a 305(c) deemed dividend, at the end of the tax form.  For illustrative purposes only.

Additionally, the cost basis of the convertible security is increased by the amount of the deemed dividend as of the entitlement date. You can see this in the Gain Loss portion of your account.

FIGURE 2: GAINSKEEPER VIEW OF DISTRIBUTIONS.

Display of the incremental increase to the cost basis of the position with each deemed dividend declared. For illustrative purposes only.

Understanding Withholding

If you are a foreign account owner, Non-Resident Alien (NRA) withholding will apply at the standard 30% rate, or at your treaty rate if applicable. If you are a U.S. taxpayer who has been notified by the IRS of a social security number/name mismatch or of underreporting on dividends and interest, backup withholding at a 24% rate will apply.

This can be complicated so if you have any questions about how these 305(c) deemed dividends are showing on your 1099 or in your GainsKeeper, please call us at 800-669-3900.  We are happy to help.

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TD Ameritrade and Wolters Kluwer Financial Services, Inc. are separate, unaffiliated companies and are not responsible for each other's policies and services. GainsKeeper is a registered trademark of Wolters Kluwer Financial Services, Inc.

TD Ameritrade does not provide tax advice. We suggest you consult with a tax-planning professional with regard to your personal circumstances.

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