The Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the rate of tax on both long-term capital gains and dividend income earned by individuals to a maximum rate of 15%, instead of the far higher ordinary income tax rates, which can be as high as 35%. In order to obtain the 15% tax rate, however, the dividend must constitute qualifying dividend income (QDI), and in order for that to occur certain requirements must be met. In October 2004, a law change added an interesting wrinkle to getting that 15% rate, which we'll cover below in the hedging discussion.

Who is Affected?

Let me make clear up front that these requirements will not affect systematic covered call writers, meaning those who buy stocks each month to write covered calls on them. The reason is that we do not acquire stocks for the purpose of capturing dividends, nor do we generally hold them long enough to even get the dividend, except by happenstance. These rules do affect portfolio covered call writers, which are those investors holding stocks long term in order to realize capital appreciation and dividends who like to write covered calls on them to generate extra income over and above dividends received.

Criteria for Claiming the 15% Rate

Congress does not - surprise - give the 15% tax rate on dividends away. In order for the dividend to constitute QDI and get the sweetheart 15% rate, several major criteria must be met:

Holding Period Requirement

As mentioned above, Congress doesn't like "dividend stripping." Uncle Sam wants you to be fully at risk in the stock for a period of time if you are to get the lower 15% dividend tax rate. This is an interesting notion, since economics texts always teach that the market prices the anticipated dividend into the stock's market price. If this is true, then dividend strippers are already paying for the dividend they are about to receive; unless of course they buy the stock far enough in advance of the ex-dividend date that the dividend has not yet been priced in. And if "strippers" buy the stock this far ahead, aren't they holding the stock long enough to be at meaningful economic risk?

Be that as it may, Congress has taken a mechanical approach to require that we be at economic risk and enforces a complex holding period. Current law provides that, in order to get the 15% rate, you must hold the dividend-paying stock for at least 61 days within the 120-day period straddling the ex-dividend date. "Straddling" means the 60 days before and after the ex-dividend date. So if the stock goes ex-dividend on July 1, you would have to hold the stock for 61 days sometime during the straddling period from roughly June 1 through September 1. Note that the day the stock is purchased is not counted, so you cannot buy the stock the day before the ex-dividend date and hold the stock for the required 61 days during the straddle period - your holding period would in that event be only 60 days, not quite enough for the dividend to be QDI.

Dividend stripping tip:   Buy at least two days before the ex-dividend date and hold the stock the full 61 days.

Is the holding period requirement really that limiting? Yes, can be, for long-term holders. It is measured by dividend, meaning that some dividends could qualify as QDI and some not. But for all four dividends in a year to qualify as QDI, you would have to hold the underlying stock, unhedged, for a minimum of 244 day. This amounts to 8 months of the year, divided into four holding periods, in which you cannot be hedged and get QDI treatment. This leaves no meaningful time between holding periods (the "holes") in which to create hedges, because the 121-day hole time available between holding periods is broken up into four periods and will not often conform to option expiration time frames in any event, as I discuss below.

Systematic covered call writers will not be concerned with the holding period requirement, since it is seldom that we will hold a stock for the required 61 days during a dividend straddle period. Long-term portfolio holders will as a general rule easily meet this requirement, since they hold the stock continuously.

But there is a wrinkle - any time that the stock is hedged does not count toward fulfilling the 61-day holding period. Next we will take a look at what constitutes hedging.

Anti-Hedging Rules

Since Uncle Sam wants you to be fully at risk in the shares, during the holding period one cannot hedge the long stock position. This means that you cannot buy a put or establish a collar during the holding period, and any covered call sold on the dividend-paying stock during the holding period must meet certain criteria discussed below. That is, any day on which the shares are hedged is not counted as part of the holding period.

The prohibition on buying puts during the required holding period makes little sense to me, since buying puts increases one's basis in stock and in that sense adds to the risk assumed. The prohibition on establishing collars (long stock + short call + long put) makes more sense, because the sale of the calls pays for the long puts, which creates a nearly riskless transaction. And as you might figure, "hedging" means more than buying puts...

Another form of hedging risk is to sell in-the-money calls on long stock, because the premium brought in reduces risk, and deeply in-the-money premiums can substantially reduce risk. (Indeed, this is one of the great benefits of writing covered calls.) In fact, sell enough calls on a stock and you will eventually reduce your basis to zero. Predictably, Uncle Sam views certain types of calls as hedging transactions. Therefore, in order not to affect a dividend's QDI status, any covered calls written on a stock during the 61-day holding period must be qualified covered calls, which are defined as those meeting the following criteria:

1. The call writer is not a dealer in the calls written;
2. There must be listed options traded on the stock, although the actual call that is written does not have to be listed;
3. The term of the call must be 30 days or more but not greater than 33 months, and
4. The call may not be deep in the money, defined as one that is more than one strike price below the closing price of the stock on the day before the call is written.

Please recall that I said above that it is difficult to write qualifying covered calls during the holes. The requirement that the calls must have at least 30 days left before expiration is what makes it tough. In order to "write the holes," you need more than just a 30-day window in which to write a call - you must have at least 30 days before expiration.

Ah, but when President Bush signed the American Jobs Creation Act of 2004 in October, a new wrinkle was added: not only must the calls written during the 61-day holding period be qualified covered calls, but in addition the calls cannot be in the money - at all - based on the stock's closing price on the trading day before the call was written. Thus if the stock closed at $30.01 yesterday and today you wrote a 30 call, it would be an in-the-money call (albeit by only one penny) and thus not qualified - - goodbye, 15%.

Note: This additional prohibition on writing in the money calls does not affect the qualified covered call definition itself and only applies in the context of determining whether dividends qualify as QDI. Therefore, writing slightly in-the-money calls still does not affect your holding period in the stock for long-term gains purposes.

Question: If an investor wrote out of the money calls but wrote more calls than are covered by the stock owned - in other words, ratio writing - would this constitute hedging that would interfere with the 61-day holding period? The answer is not clear.

Summary

To wrap up this discussion, for your dividends to qualify as QDI and receive the 15% dividends tax rate:

• Holding Period.  You must hold the stock for at least 61 days (not counting the day you buy the stock) of the 120-day period straddling the ex-dividend date - this applies to every dividend separately.
• No Hedging.  During the 61-day holding period:
  • you may not buy puts or create a collar, and
  • any calls written must be qualified covered calls (see four-point test above) that are out of the money

By the way, this QDI litmus test must be met as to every separate dividend.

Treatment of In-Lieu Dividends

Here is another trap that I want to quickly cover. When shares are held in a margin account, and the investor has borrowed against the account, the broker may borrow shares from the investor. If the stock loan crosses a dividend payment date, the investor will not receive any dividend paid by the corporation. Instead, the investor will receive an “in lieu of dividend" payment. This is paid by the stock borrower, who always pays dividends. The “in lieu” payments do not qualify as QDI. Instead, they will be taxed at ordinary income rates. For the 2004 tax year, brokers will be obligated to track in-lieu payments - they didn't have to for 2003.

If getting the 15% tax rate on dividends is driving your activity, consider separating out the high-dividend stocks into a separate cash account, so that the stocks cannot be borrowed.

Does it Matter?

I write systematically and don't trade to capture dividends, so I only get them when I happen to be in a trade across an ex-dividend date. Not being able to write deep ITM calls would at times cramp my trading style, if I cared about the 15% rate. But since I trade in and out of stocks and don't hold long term. For these reasons, I am not trying to get the QDI 15% dividend tax rate, thus the holding period requirement and the restriction on hedging won't matter in my trading. Those of you who also write covered calls systematically probably won't be affected, either, since you are, like me, writing for premium income, not to capture dividends. For us systematic writers, this article is primarily of academic interest. On non-dividend growth stocks, these rules also do not matter.

So when do the rules matter?

Those of you who hold dividend stocks long-term and who like to hedge or sell covered calls need to be familiar with these rules, at least on stocks that pay a high enough dividend that the 15% dividends tax rate is meaningful. The restriction on writing in-the-money calls will not in and of itself matter that much to long-term equity holders. Because their goal is to hold the stock for long-term gain, they do not want to be called out, so they would not normally write in the money in any event. Long-term holders typically write out of the money anyway in order to avoid getting called out and losing their stock - or resetting their tax holding period. Thus long-term holders are more affected by the inability to collar or just buy protective puts than they are by the restriction on writing in-the -money calls.

For more information concerning federal taxation of stocks and options, please see the following archived MONEY newsletter article: http://www.callwriter.com/newsletter/taxrules.htm

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