Despite the fact that earning dividends requires no active participation on the part of the shareholder, they do not meet the criteria for passive income as outlined by the Internal Revenue Service (IRS). However, depending on how long you have owned your stock, your dividends may be considered qualified and could be taxed as a capital gains rather than 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 payment is not mandatory, many companies choose to issue dividends each year to illustrate their profitability and encourage additional investment. Dividends are paid either in cash or additional shares of stock.
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 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.
Because dividends do not fall into one of these two categories, they are considered ordinary income.
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.
Qualified dividends 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 December 1, for example, then you must have owned the stock for at least 60 days during the period between June 3 and October 2.