Chapter 5, Problem 36 – Sean, a shareholder of Crimson Corporation, is single and in the 35% tax bracket.

This year, he receives a

$7,000 qualified dividend from Crimson. Sean has investment interest expense of $16,000 and net investment income of $9,000
(not including the qualified dividend). Assume that Sean does not expect to have any investment income in the foreseeable
future. Should Sean treat the distribution as a qualified dividend (subject to a 15% tax rate) or classify it as net investment
income?

NOTES

(page 5-13) Qualified dividends are not considered investment income when determining the investment interest expense
deduction. Taxpayers can, however, elect to treat qualified dividends as ordinary income (taxed at regular rates) and include
them in investment interest income. As a result, taxpayers subject to an investment interest expense limitation must evaluate the
relative benefits of taxing qualified dividends at reduced rates versus using the dividends as investment income to increase the
amount of deductible investment interest expense.

You can only take a deduction for investment interest expenses that is lesser than or equal to your net investment income. For
example, if you have $3,000 in margin interest but net investment income of only $1,000, you can only deduct the $1,000 in
investment interest in the current year.

Qualified Dividend $7000

Investment Interest Expense $16000
Net Investment Income $9000

If treated as Qualified Dividend –

$7000 x 15% = $1050

OR

Classify it as net investment income – Taxpayers can, however, elect to treat qualified dividends as ordinary income (taxed at
regular rates) and include them in investment interest income –

*If treated as Net Investment Income and Investment Interest Expense Deduction.

[(Qualified Dividend – Investment Interest Expense)] x 35%

$7000 – $7000 = $0

--

*If treated as Net Investment Income and did not have Investment Interest Expense.

$7000 x 35% = $2450

Sean should classify the distribution as Net Investment Income because he would have no tax liability.

However, Sean can potentially save $1400 in taxes ($2450 taxes saved in the future – $1050 taxes paid via qualifying dividend
treatment). But since tax savings will not be available for many years, Sean should perform a present-value analysis. This way,
Sean will know if the expected present value of the $2450 (taxes saved in the future) is less than the current tax of $1050.