Are Dividends Considered Passive Income?

Dividends are distributions of a company’s earnings to shareholders, a common return for stock investors. While dividends might feel like “passive” earnings because they require no active effort from the investor, their classification under U.S. tax law, specifically as “passive income,” is a distinct and often misunderstood concept.

Defining Passive Income for Tax Purposes

For tax purposes, “passive income” has a very specific meaning, defined under Internal Revenue Code Section 469. This section aims to prevent taxpayers from using losses from passive activities to offset active business income or portfolio income. A passive activity is generally defined as any trade or business in which the taxpayer does not materially participate. It also includes any rental activity, regardless of the taxpayer’s participation level, with some exceptions.

Material participation means the taxpayer is involved in the operation of the activity on a regular, continuous, and substantial basis. Examples of income typically considered passive activity income include earnings from rental properties where the owner is not a real estate professional or income from interests in limited partnerships where the investor is not actively involved in management.

Dividends: Portfolio Income vs. Passive Activity Income

Most dividends received from publicly traded companies or other common investment vehicles are generally classified as “portfolio income” by the IRS, not “passive activity income.” Portfolio income includes earnings from interest, dividends, annuities, and royalties that are not derived in the ordinary course of a trade or business. This distinction is important because portfolio income is treated differently from passive activity income under the passive activity loss rules.

The passive activity loss rules generally restrict taxpayers from deducting passive losses against non-passive income. Since dividends are considered portfolio income, they are typically not subject to these passive activity loss limitations. While dividends arrive without direct effort, tax law does not categorize them as income from a “passive activity” for offsetting passive losses. Therefore, investors cannot use passive activity losses to offset dividend income.

Understanding Dividend Tax Treatment

The tax treatment of dividends varies primarily based on whether they are classified as “qualified” or “non-qualified” (ordinary) dividends. Qualified dividends typically originate from U.S. corporations or qualified foreign corporations and must be held for a specific period, usually more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. These qualified dividends are taxed at preferential long-term capital gains rates, which are often lower than ordinary income tax rates. The specific rate depends on the taxpayer’s income bracket.

Non-qualified dividends, also known as ordinary dividends, are taxed at the taxpayer’s ordinary income tax rates, which can be significantly higher than capital gains rates. These include dividends from certain entities like real estate investment trusts (REITs), master limited partnerships (MLPs), or employee stock options. Additionally, dividends, whether qualified or ordinary, can be subject to the Net Investment Income Tax (NIIT) under Internal Revenue Code Section 1411. This 3.8% tax applies to certain high-income taxpayers on their net investment income, which includes most dividends, interest, and capital gains.

Source-Specific Dividend Classifications

While most investment dividends are portfolio income, the source of a distribution can sometimes influence its classification, especially in the context of closely held businesses. For instance, distributions from an S-corporation or partnership are typically reported on a Schedule K-1. If a taxpayer has an ownership interest in such an entity but does not materially participate in its operations, the income generated by that entity could be considered passive activity income.

In such cases, any distributions, while not technically “dividends” in the corporate sense, would retain the character of the underlying activity. This means that if the business activity is deemed passive for the investor due to a lack of material participation, then distributions stemming from that activity would be treated as passive income. This differs significantly from dividends received from publicly traded corporations, where the investor’s lack of participation is irrelevant to the dividend’s portfolio income classification. The key distinction lies in whether the distribution arises from a direct interest in an underlying trade or business where the material participation rules apply.