Some investors pick specific stocks based on their dividend payout. Dividends are a way to earn a consistent income stream on a regular basis. A certain stock may not be a growth value option, but if it pays out a dividend, it provides its benefit in that manner.

Many older investors or those retired prefer dividend stocks, particularly since higher-dividend paying stocks are from successful, well-established companies. This provides a lower risk profile for investors that are in the late stage of their investing life.

Despite the fact that earning dividends requires no active participation on the part of the shareholder, dividends do not meet the criteria for passive income as outlined by the Internal Revenue Service (IRS). Being considered passive income is beneficial as it incurs a capital gains tax, which is much lower than tax rates on ordinary income. Ideally, an investor would prefer to be taxed at a capital gains tax rate.

Depending on how long you have owned your stock and where the corporation that issues it exists, however, your dividends may be considered qualified and could be taxed as capital gains as opposed to ordinary income.

What Are Dividends?

Dividends are a way for publicly traded companies to redistribute profits to shareholders as a reward for their investment. Though dividend payments are not mandatory, many companies choose to issue dividends to illustrate their profitability and encourage additional investment. Dividends are paid either in cash or in additional shares of stock, and depending on the company, are paid at different intervals; sometimes quarterly, bi-annually, or annually.

Dividends come from a company's retained earnings. They specifically come from unappropriated retained earnings. Unappropriated retained earnings are the portion of retained earnings that have not been earmarked for use in specific business purposes, such as buying new machinery.

A company's stock is usually issued as preferred stock or common stock. Preferred stock has priority over common stock, meaning that preferred stockholders are paid dividends first. However, preferred stock does not contain voting rights, which common stock does. The more common stock an investor owns, the more influence they can have on a company.

Passive Income

Passive income, as defined by the IRS, can only be generated by rental activity or by a business in which you have a financial interest in but do not play an active role. If you own a home that you rent out, any income that your renters pay to you is considered passive income, including any fees you may charge.

Outside of your role as a landlord, the only other way to create passive income is to bankroll a business that you do not actively participate in, commonly called being a silent partner.

Dividends are considered portfolio income, which is a type of passive income, but the IRS stipulates many rules around what can be considered passive or not. Because dividends do not fall into one of the two categories described as passive income above, they are considered ordinary income and so do not qualify for capital gains tax.

Qualified Dividends

Though most dividends paid by corporations or mutual funds are considered ordinary dividends, some may be considered qualified dividends. In these cases, your dividend income is subject to the capital gains tax rate rather than your income tax rate, which is higher.

To be considered a qualified dividend, a dividend must be paid by an American corporation or a qualified foreign entity. In addition, you must have held the stock for which the dividend was paid for at least 60 days within the 121-day period that ends 60 days prior to the ex-dividend date. If the ex-dividend date is Dec. 1, for example, then you must have owned the stock for at least 60 days during the period between June 3 and Oct. 2.

The Bottom Line

Passive income qualifies for capital gains tax, which is a lower rate than ordinary income tax, making it more attractive; however, dividends do not fall under the passive income category as defined by the IRS, so are taxed at regular income tax rates. The only exception is if the dividends are qualified dividends by meeting certain criteria. In this case, dividends are held to capital gains tax.