What is a substitute dividend?

Assets held in margin accounts where the account owner is carrying a debit balance are generally subject to rehypothecation (being loaned out).

When margined shares are loaned by the financial institution where the account is held, substitute (rather than actual) dividends may be allocated to that account.  Under the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA 2003), substitute dividends do not qualify for the lower tax rates on qualified dividends.

If you receive a substitute dividend in 2005 and beyond, some financial institutions plans to credit their account to eliminate any adverse tax implications to them. Ask your financial institution about their policies on substitute dividend. 

Where is a substitute dividend reported for tax purposes?

Substitute dividends are reported as “substitute payments in lieu of dividends or interest” in box 8 of IRS Form 1099-MISC and the additional credit to your account is reported on the same form as “other income”. You have to report both items as “other income“ on Form 1040.