A dividend in lieu is taxed as ordinary income at rates up to 37% in 2026, not at the 0%, 15%, or 20% qualified dividend rates. That single reclassification can nearly double the federal tax on the same cash. It happens because the payment comes from whoever borrowed your shares, not from the corporation’s earnings, and the IRS treats it as a contractual substitute rather than a real dividend.
Why a Substitute Payment Loses Qualified Status
When your shares sit in a margin account and your brokerage lends them out, the borrower (usually a short seller) sells them into the market. If the corporation pays a dividend while the shares are on loan, the borrower owes you an equivalent cash amount. That cash is the dividend in lieu, sometimes labeled “Substitute Payment,” “Payment in Lieu,” “PIL,” or “S-Div” on your statement.
The problem is that your shares were transferred out of your name during the loan. Qualified dividend treatment requires you to hold the stock across a specific window around the ex-dividend date, and a loaned position doesn’t meet it. The payment loses its qualified character entirely, and IRS Publication 550 is explicit that you “do not treat these substitute payments as dividends or interest.”1Internal Revenue Service. Publication 550 (2025), Investment Income and Expenses – Reporting Substitute Payments
What the Rate Difference Costs You
For 2026, a single filer pays 0% on qualified dividends up to $49,450 in taxable income and doesn’t reach the 20% rate until income exceeds $545,500. Ordinary rates climb to 37% for single filers with taxable income above $640,600.2Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
On a $10,000 payment, a taxpayer in the 20% qualified bracket pays $2,000. The same $10,000 received as a dividend in lieu at the 37% ordinary rate costs $3,700. That’s $1,700 more in federal tax on identical cash, and the lending decision was typically made by the brokerage, not by you.
Foreign Stock
If the loaned shares are in a foreign company, you also lose the foreign tax credit. An actual dividend from a foreign corporation may qualify for the credit against foreign taxes withheld at the source. A substitute payment is a domestic contractual arrangement between you and the borrower, so no credit applies even though the payment is designed to mimic the foreign dividend.
Municipal Bonds
The same trap applies to tax-exempt securities. A substitute payment received in lieu of tax-exempt municipal bond interest is fully taxable as ordinary income. The tax-exempt character belongs to the interest paid by the issuer, not to a contractual substitute from a borrower.
The 3.8% Net Investment Income Tax
Higher earners face an additional layer. The Net Investment Income Tax adds 3.8% on investment income above $200,000 for single filers and $250,000 for married couples filing jointly. These thresholds are not adjusted for inflation.3Internal Revenue Service. Topic No. 559, Net Investment Income Tax
Substitute payments are income from investment property, so they count toward net investment income. Stacked on top of ordinary rates, a top-bracket investor can pay an effective federal rate of 40.8% on a dividend in lieu, compared with 23.8% on the same amount received as a qualified dividend.
How to Report a Dividend in Lieu
Your brokerage reports the payment on Form 1099-MISC, Box 8, labeled “Substitute payments in lieu of dividends or interest.”4Internal Revenue Service. Form 1099-MISC (Rev. April 2025) That box label is the clearest signal that the income is ordinary.
Report the amount as “Other income” on Schedule 1 (Form 1040), line 8z.1Internal Revenue Service. Publication 550 (2025), Investment Income and Expenses – Reporting Substitute Payments It does not belong on Form 1040 line 2b with your dividends, and it does not belong on Schedule B. Putting it there can trigger an IRS notice because the 1099-MISC won’t match.
Watch for one point of confusion. The IRS allows brokerages to include substitute payment information on a composite statement alongside Form 1099-DIV,5Internal Revenue Service. Instructions for Form 1099-DIV (01/2024) and seeing the amounts near your dividend figures can make them look like they belong together. They don’t. Substitute payments are not reported on Form 1099-DIV itself. If your composite statement bundles the figures, check the supplemental detail and separate them before filing.
How to Avoid Receiving One
The cleanest fix is holding shares in a cash account rather than a margin account. In a cash account, the brokerage generally cannot lend your shares without your explicit agreement. Standard margin agreements, by contrast, typically grant the brokerage the right to lend out securities without specific notice whenever you have an outstanding margin loan.6Investor.gov. Investor Bulletin: Understanding Margin Accounts If you don’t actually use margin borrowing, switching account types eliminates the problem.
If you need margin, ask your brokerage whether your agreement permits securities lending and whether you can opt out. Some firms offer a securities lending opt-out for fully paid shares even inside a margin account, though the specifics vary.
Some brokerages also run “fully paid lending programs” where you knowingly agree to lend shares in exchange for a share of the lending revenue, often around 50% of the interest earned. Enrolling means trading the qualified dividend rate for a combination of lending income and an ordinary-rate substitute payment. Run the numbers before signing up, because the lending revenue may not cover the extra tax.
For high-dividend positions in taxable accounts, where the qualified rate matters most, keeping those specific holdings in a cash account or an IRA is often the tidiest solution. Inside a traditional or Roth IRA, the distinction between a real dividend and a substitute payment has no immediate tax impact, so lending activity in those accounts doesn’t create the rate penalty. Reserve the margin account for positions where the dividend yield is minimal.
A Note If You’re the Short Seller
If you’re on the other side of this transaction as the borrower, the substitute payment you pay is potentially deductible, but the rules are their own subject: a 45-day holding threshold determines whether the payment is deductible or capitalized into basis, and any deduction is treated as investment interest under IRC Section 163(d), subject to the investment interest limitation and reportable only as an itemized deduction.7Internal Revenue Service. Publication 550 (2025), Investment Income and Expenses – Payments in Lieu of Dividends8Office of the Law Revision Counsel. 26 U.S. Code 163 – Interest That path involves Form 4952 and interacts with wash sale rules under IRC Section 1091 when short positions close at a loss.9Office of the Law Revision Counsel. 26 U.S. Code 1091 – Loss From Wash Sales of Stock or Securities If you’re receiving the payment rather than making it, none of that applies to you.