Posted by Larry Hurt

Substitute Payment in Lieu of Dividends

Substitute Payment in Lieu of Dividends

The payment in lieu of dividends subject occurs in connection with the short sale of stocks. Short-term selling is a business strategy of selling the shares that an operator does not own and repurchasing them at a lower price, thus benefiting from lower rates. If the shares sold pay dividends, payment will be made.

How Substitute payments in lieu works

Substitute payments in lieu of dividends spring from the fact that your broker lends the shares you own to short sellers. These short-sellers borrow their shares and then sell them on the open market, relying on the fact that they will have a lower value before having to repurchase them and return the shares.

If the security pays a dividend in the period it was borrowed, the short sellers must repay the lost dividend income. This refund is the replacement payment made in lieu of profits that would otherwise have been received directly by the issuing corporation.

Short term sale

To sell short, a merchant must first borrow the shares of a broker. A broker will acquire shares for the quick sale of his shares or lend shares to clients who own shares in his accounts. If a dealer sells shorted shares and these shares pay dividends, he is required to pay the amount of the dividend to the dealer. The money that the seller pays is not the actual dividend, but a payment instead of the dividend.

Borrow shares

A margin account agreement allows the broker to borrow shares from the customer's margin account with outstanding margin loans. A client whose shares have been acquired will not know that the actual shares have been adopted. However, if these shares receive dividends, the customer will receive the payment instead of the dividend. The broker will inform the client that this has occurred.

Tax consequences

Dividends earned can benefit from a lower tax rate. The maximum dividend tax rate is 15%, compared to a maximum rate of 35%. If an investor receives payment instead of dividends from eligible dividends, this payment is not eligible for tax, and the investor must pay the highest standard tax rate. The broker will issue a 1099-MISC form that lists the payment, rather than the dividends for the investor.

The disadvantage of payments in lieu

The whole point of payment in lieu, rather than dividends, is to supplement the original shareholder. However, payments in lieu present a severe disadvantage: they cannot benefit from tax quotas to obtain qualified dividends. Currently, eligible dividends have maximum rates ranging from 0% to 20%, depending on the usual tax bracket. However, they still save at least ten percentage points of the tax rate paid for dividends.

Payments in lieu cannot benefit from this favorable treatment and are taxed on ordinary income. If these rates rise to 39.6%, payments can be a costly tax problem.

How to prevent payments in lieu 

There is a way to ensure that you never have to make substitute payments instead of dividends: choose a cash brokerage account instead of a marginal brokerage account. In a cash account, your broker can not use your shares to lend to small sellers, which prevents the payment in the place of the situation. Instead, a margin account usually includes provisions allowing the broker to borrow your shares at any time.

Substitute payments in lieu of dividends are essential for income-oriented investors because they ensure you get the income you deserve. However, the negative tax effect means that payments are avoided rather than accepted.

Broker considerations

Brokers do not want clients to receive payments instead of the average stock dividend. In the case of a dividend-paying stock, a dealer may refuse to lend shares to customers on the day of the dividend distribution and may withdraw dividend-paying stock from short sellers. The broker has the right to require a short seller to repay the borrowed shares sold. Some brokers will pay credit on account of an investor who has received a payment instead of offsetting the difference by paying a higher tax rate.

Larry Hurt
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