Publication 550
Investment Income and Expenses

(Including Capital Gains and Losses)

For use in preparing 2002 Returns

1. Investment Income

Topics

This chapter discusses:

• Interest income,
• Dividends and other corporate distributions,
• Real estate mortgage investment conduits (REMICs), financial asset securitization investment trusts (FASITs), and other collateralized debt obligations (CDOs),
• S corporations, and
• Investment clubs.

Useful Items

You may want to see:

Publication

• 525   Taxable and Nontaxable Income
• 537   Installment Sales
• 564   Mutual Fund Distributions
• 590   Individual Retirement Arrangements (IRAs)
• 925   Passive Activity and At-Risk Rules
• 1212   List of Original Issue Discount Instruments

Form (and Instructions)

• Schedule B (Form 1040)   Interest and Ordinary Dividends
• Schedule 1 (Form 1040A)   Interest and Ordinary Dividends for Form 1040A Filers
• 1099   General Instructions for Forms 1099, 1098, 5498, and W-2G
• 3115   Application for Change in Accounting Method
• 6251   Alternative Minimum Tax - Individuals
• 8582   Passive Activity Loss Limitations
• 8615   Tax for Children Under Age 14 Who Have Investment Income of More Than $1,500
• 8814   Parents' Election To Report Child's Interest and Dividends
• 8815   Exclusion of Interest From Series EE and I U.S. Savings Bonds Issued After 1989
• 8818   Optional Form To Record Redemption of Series EE and I U.S. Savings Bonds Issued After 1989

See chapter 5 for information about getting these publications and forms.

General Information

A few items of general interest are covered here.

Recordkeeping. You should keep a list showing sources and amounts of investment income that you receive during the year. Also, keep the forms you receive that show your investment income (Forms 1099-INT, Interest Income, and 1099-DIV, Dividends and Distributions, for example) as an important part of your records.

Tax on investment income of a child under age 14.   Part of a child's 2002 investment income may be taxed at the parent's tax rate. This may happen if all of the following are true.

1. The child was under age 14 at the end of 2002. A child born on January 1, 1989, is considered to be age 14 at the end of 2002.
2. The child had more than $1,500 of investment income (such as taxable interest and dividends) and has to file a tax return.
3. Either parent was alive at the end of 2002.

If all of these statements are true, Form 8615 must be completed and attached to the child's tax return. If any of these statements is not true, Form 8615 is not required and the child's income is taxed at his or her own tax rate.

However, the parent can choose to include the child's interest and dividends on the parent's return if certain requirements are met. Use Form 8814 for this purpose.

For more information about the tax on investment income of children and the parents' election, see Publication 929, Tax Rules for Children and Dependents.

Beneficiary of an estate or trust.   Interest, dividends, and other investment income you receive as a beneficiary of an estate or trust is generally taxable income. You should receive a Schedule K-1 (Form 1041), Beneficiary's Share of Income, Deductions, Credits, etc., from the fiduciary. Your copy of Schedule K-1 and its instructions will tell you where to report the income on your Form 1040.

Social security number (SSN).   You must give your name and SSN to any person required by federal tax law to make a return, statement, or other document that relates to you. This includes payers of interest and dividends.

SSN for joint account.   If the funds in a joint account belong to one person, list that person's name first on the account and give that person's SSN to the payer. (For information on who owns the funds in a joint account, see Joint accounts, later.) If the joint account contains combined funds, give the SSN of the person whose name is listed first on the account.

These rules apply both to joint ownership by a married couple and to joint ownership by other individuals. For example, if you open a joint savings account with your child using funds belonging to the child, list the child's name first on the account and give the child's SSN.

Custodian account for your child.   If your child is the actual owner of an account that is recorded in your name as custodian for the child, give the child's SSN to the payer. For example, you must give your child's SSN to the payer of dividends on stock owned by your child, even though the dividends are paid to you as custodian.

Penalty for failure to supply SSN.   You will be subject to a penalty if, when required, you fail to:

1. Include your SSN on any return, statement, or other document,
2. Give your SSN to another person who has to include it on any return, statement, or other document, or
3. Include the SSN of another person on any return, statement, or other document.

The penalty is $50 for each failure up to a maximum penalty of $100,000 for any calendar year.

You will not be subject to this penalty if you can show that your failure to provide the SSN was due to a reasonable cause and not to willful neglect.

If you fail to supply an SSN, you may also be subject to backup withholding.

Backup withholding.   Your investment income is generally not subject to regular withholding. However, it may be subject to backup withholding to ensure that income tax is collected on the income. Under backup withholding, the bank, broker, or other payer of interest, original issue discount (OID), dividends, cash patronage dividends, or royalties must withhold, as income tax, a percentage of the amount you are paid. For 2003, the percentage is 30%.

Backup withholding applies if:

1. You do not give the payer your identification number (either a social security number or an employer identification number) in the required manner,
2. The Internal Revenue Service (IRS) notifies the payer that you gave an incorrect identification number,
3. The IRS notifies the payer that you are subject to backup withholding on interest or dividends because you have underreported interest or dividends on your income tax return, or
4. You are required, but fail, to certify that you are not subject to backup withholding for the reason described in (3).

Certification.   For new accounts paying interest or dividends, you must certify under penalties of perjury that your social security number (SSN) is correct and that you are not subject to backup withholding. Your payer will give you a Form W-9, Request for Taxpayer Identification Number and Certification, or similar form, to make this certification. If you fail to make this certification, backup withholding may begin immediately on your new account or investment.

Underreported interest and dividends.   You will be considered to have underreported your interest and dividends if the IRS has determined for a tax year that:

1. You failed to include any part of a reportable interest or dividend payment required to be shown on your return, or
2. You were required to file a return and to include a reportable interest or dividend payment on that return, but you failed to file the return.

How to stop backup withholding due to underreporting.   If you have been notified that you underreported interest or dividends, you can request a determination from the IRS to prevent backup withholding from starting or to stop backup withholding once it has begun. You must show that at least one of the following situations applies.

1. No underreporting occurred.
2. You have a bona fide dispute with the IRS about whether underreporting occurred.
3. Backup withholding will cause or is causing an undue hardship, and it is unlikely that you will underreport interest and dividends in the future.
4. You have corrected the underreporting by filing a return if you did not previously file one and by paying all taxes, penalties, and interest due for any underreported interest or dividend payments.

If the IRS determines that backup withholding should stop, it will provide you with a certification and will notify the payers who were sent notices earlier.

How to stop backup withholding due to an incorrect identification number.   If you have been notified by a payer that you are subject to backup withholding because you have provided an incorrect SSN or employer identification number, you can stop it by following the instructions the payer gives you.

Reporting backup withholding.   If backup withholding is deducted from your interest or dividend income or other reportable payment, the bank or other business must give you an information return for the year (for example, a Form 1099-INT) that indicates the amount withheld. The information return will show any backup withholding as Federal income tax withheld.

Nonresident aliens.   Generally, payments made to nonresident aliens are not subject to backup withholding. You can use Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding, to certify exempt status. However, this does not exempt you from the 30% (or lower treaty) withholding rate that may apply to your investment income. For information on the 30% rate, see Publication 519, U.S. Tax Guide for Aliens.

Penalties.   There are civil and criminal penalties for giving false information to avoid backup withholding. The civil penalty is $500. The criminal penalty, upon conviction, is a fine of up to $1,000, or imprisonment of up to 1 year, or both.

Where to report investment income.   Table 1-1 gives an overview of the forms and schedules to use to report some common types of investment income. But, see the rest of this publication for detailed information about reporting investment income.

Joint accounts.   If two or more persons hold property (such as a savings account, bond, or stock) as joint tenants, tenants by the entirety, or tenants in common, each person's share of any interest or dividends from the property is determined by local law.

Example.   You and your husband have a joint money market account. Under state law, half the income from the account belongs to you, and half belongs to your husband. If you file separate returns, you each report half of the income.

Income from property given to a child.   Property you give as a parent to your child under the Model Gifts of Securities to Minors Act, the Uniform Gifts to Minors Act, or any similar law, becomes the child's property.

Income from the property is taxable to the child, except that any part used to satisfy a legal obligation to support the child is taxable to the parent or guardian having that legal obligation.

Savings account with parent as trustee.   Interest income from a savings account opened for a child who is a minor, but placed in the name and subject to the order of the parents as trustees, is taxable to the child if, under the law of the state in which the child resides, both of the following are true.

1. The savings account legally belongs to the child.
2. The parents are not legally permitted to use any of the funds to support the child.

(For detailed information about reporting investment income, see the rest of this publication, especially How To Report Interest Income and How To Report Dividend Income) in chapter 1.

Accuracy-related penalty.   An accuracy-related penalty of 20% can be charged for underpayments of tax due to negligence or disregard of rules or regulations or substantial understatement of tax. For information on the penalty and any interest that applies, see Penalties in chapter 2.

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