Tax Court differentiates interest and dividends

A recent Tax Court case confirms that dividends receive different treatment from interest.

Investors who purchase bonds are generally aware of the accrued interest rule: When you purchase a bond between coupon dates, or the dates on which the bond issuer pays interest, you have to pay the seller any interest that has accrued since the last coupon date, in addition to the purchase price of the bond.

Suppose the bond pays $600 in interest every six months. If you purchase the bond one month after the last coupon date, the seller of the bond has already earned $100 of interest. In addition to the bond's purchase price, you will pay $100 to the seller, representing the accrued interest.

On the next coupon date, you will collect $600 of interest from the bond issuer. However, since you paid $100 of that interest to the seller, you will be taxed on only $500 of interest - the $600 cash you receive, less the $100 you paid to the seller of the bond. The seller is taxed on that $100 of interest.

In a recent Tax Court case (George E. Ham v. Commissioner, T.C. Summary Opinion 2012-3, Jan. 5, 2012), George Ham tried to apply a similar principle to dividends received on mutual funds.

When Ham purchased mutual fund shares between dividend dates, a part of the price he paid for the shares represented accrued dividends. He argued that a portion of an actual dividend distribution he received at the next dividend date should be nontaxable, since – as with accrued interest on bonds – he had "paid" part of the dividend to the former owner of the mutual fund shares.

Unfortunately for Ham, the court found no authority for his argument anywhere in the tax law. Ham had to pay tax on the full amount of the dividend.

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