Does money paid in lieu of dividend count against qualified dividend income?

Question

I am short an ETF and will pay the dividend to whoever owns the ETF, in lieu of dividend. However, most of my dividend income is in the form of qualified dividends.

Will the payment in lieu of dividend get treated separately from my qualified dividend income or will it partially cancel out my qualified dividend income for tax purposes?

Let's say I pay out $100 in payment in lieu of dividend, but receive $200 worth of qualified dividends. Will I simply get taxed as having $100 worth of qualified dividend income or will I get to claim a loss on the $100 paid and a gain on the $200 received? The latter has more favorable tax treatment (gain $200 at 15% qualified tax rate, deduct loss on $100 at ordinary income tax rate).

Answer 1

Dividend paid to owners of shorted shares is not qualified for preferential tax treatment. See IRC Sec. 26 and Publication 550:

Dividends that are not qualified dividends.

The following dividends are not qualified dividends. They are not qualified dividends even if they are shown in box 1b of Form 1099-DIV.

• Capital gain distributions.
• Dividends paid on deposits with mutual savings banks, cooperative banks, credit unions, U.S. building and loan associations, U.S. savings and loan associations, federal savings and loan associations, and similar financial institutions. Report these amounts as interest income.
• Dividends from a corporation that is a tax-exempt organization or farmer's cooperative during the corporation's tax year in which the dividends were paid or during the corporation's previous tax year.
• Dividends paid by a corporation on employer securities held on the date of record by an employee stock ownership plan (ESOP) maintained by that corporation.
• Dividends on any share of stock to the extent you are obligated (whether under a short sale or otherwise) to make related payments for positions in substantially similar or related property.
• Payments in lieu of dividends, but only if you know or have reason to know the payments are not qualified dividends.
• Payments shown on Form 1099-DIV, box 1b, from a foreign corporation to the extent you know or have reason to know the payments are not qualified dividends.

Your payment in lieu of dividend to those from whom you borrowed is deductible as an investment expense, so it doesn't cancel the dividend directly but instead you deduct it on Schedule A line 9 (see instructions and details on Form 4952).