A dividend in lieu — the substitute cash payment you receive when your shares were on loan through securities lending on a dividend date — is taxed as ordinary income at your marginal rate, which can reach 37% in 2026. That treatment strips away the preferential 0%, 15%, or 20% rate that qualified dividends enjoy, and the payment gets reported as “Other income” on Schedule 1, not with your dividends. The cash looks identical to a real dividend when it lands in your account, but the IRS treats it as a contractual payment from the borrower of your shares rather than a distribution of corporate earnings, and that single distinction drives the entire tax outcome.
Why You Received One Instead of a Real Dividend
Your brokerage temporarily transferred your shares to a borrower, usually a short seller, who then sold them on the open market. When the corporation paid its dividend, the shares were no longer in your name, so the corporation paid someone else. The borrower’s account owes you an equivalent cash amount, and that transfer is the dividend in lieu. Your brokerage statement labels it something like “Substitute Payment,” “Payment in Lieu,” “PIL,” or “S-Div.”
A qualified dividend requires you to hold the stock for at least 61 days within the 121-day window beginning 60 days before the ex-dividend date. Shares out on loan don’t satisfy that holding requirement, so the payment can’t qualify no matter how long you’ve owned the position otherwise.
What the Rate Difference Actually Costs
Qualified dividends are taxed at long-term capital gains rates: 0%, 15%, or 20% depending on income. For 2026, a single filer pays 0% on qualified dividends up to $49,450 of taxable income and doesn’t hit the 20% rate until income exceeds $545,500. A dividend in lieu gets none of that. It’s taxed at your marginal ordinary rate, which tops out at 37% for single filers with taxable income above $640,600 in 2026.1Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
In dollars: on a $10,000 payment, a taxpayer in the 20% qualified bracket pays $2,000. The same $10,000 as a dividend in lieu at the 37% ordinary rate costs $3,700. That’s an extra $1,700 in federal tax on the same cash, and nothing about the economic transaction changed from your point of view.
IRS Publication 550 is direct about the classification: “Do not treat these substitute payments as dividends or interest.”2Internal Revenue Service. Publication 550 (2025), Investment Income and Expenses – Reporting Substitute Payments
Foreign Stocks Lose the Foreign Tax Credit
If the loaned shares were in a foreign company, the damage compounds. An actual dividend from a foreign corporation may qualify for the foreign tax credit, which offsets taxes withheld at the source. A substitute payment is a domestic contractual arrangement between you and the borrower, so no foreign tax credit attaches. You lose the preferential rate and the credit on the same payment.
Municipal Bond Interest Loses Its Exemption
The same logic cuts into tax-exempt income. If you lend out municipal bonds and receive a substitute payment in place of the tax-exempt interest, that payment is fully taxable as ordinary income. The tax-exempt character belongs to interest paid by the issuer, not to a contractual substitute from a borrower.
The 3.8% Net Investment Income Tax Still Applies
Higher earners face another layer. The 3.8% Net Investment Income Tax applies to investment income above $200,000 for single filers and $250,000 for married couples filing jointly. These thresholds are not indexed to inflation.3Internal Revenue Service. Topic No. 559, Net Investment Income Tax
Substitute payments derive from investment property, so they count as net investment income for NIIT purposes. A top-bracket investor can face an effective federal rate of 40.8% (37% ordinary plus 3.8% NIIT) on a dividend in lieu, against 23.8% on the same amount received as a qualified dividend. On $10,000, that gap is $1,700 of additional federal tax from the rate change alone.
How to Report It on Your Return
Substitute payments do not belong on Form 1040, line 2b with your ordinary dividends, and they don’t belong on Schedule B as dividend income. Report them as “Other income” on Schedule 1 (Form 1040), line 8z.2Internal Revenue Service. Publication 550 (2025), Investment Income and Expenses – Reporting Substitute Payments Mixing them in with qualified dividends is a common mistake that can trigger an IRS notice because the amounts won’t reconcile with the forms the IRS received.
Your brokerage reports the payment to you and the IRS 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.
Watch out for one trap. The IRS allows brokerages to include substitute payment information on a composite statement alongside your Form 1099-DIV.5Internal Revenue Service. Instructions for Form 1099-DIV (01/2024) Seeing the amounts stacked near your dividend figures makes them look like they belong together. They don’t. Substitute payments in lieu of dividends are not reported on Form 1099-DIV itself. If your composite statement bundles the numbers, check the supplemental detail and separate out the substitute payments before you file.
How to Spot a Substitute Payment on Your Statements
Most individual investors run into these payments because they hold shares in a margin account. Standard margin agreements typically give the brokerage the right to lend out your securities whenever you have an outstanding margin loan, without specific notice.6Investor.gov. Investor Bulletin: Understanding Margin Accounts The brokerage keeps the lending revenue; you absorb the tax consequences.
Scan your monthly statements for line items labeled “Substitute Payment,” “Payment in Lieu,” “PIL,” or “S-Div.” Any of those labels means the income is ordinary, regardless of what the underlying company called its distribution. At year-end, confirm the amount appears in Box 8 of a Form 1099-MISC, and carry it to Schedule 1, line 8z.
One place the distinction doesn’t bite: tax-advantaged accounts. In a traditional or Roth IRA, the character of the income has no immediate tax impact, so a substitute payment inside those accounts doesn’t change what you owe. The rate penalty only matters in taxable accounts.
How to Stop Receiving Them
The cleanest prevention is holding your shares in a cash account instead of a margin account. In a cash account, the brokerage generally cannot lend your shares without your explicit agreement.6Investor.gov. Investor Bulletin: Understanding Margin Accounts If you don’t actually need margin borrowing, converting the account removes the issue entirely.
If you want to keep the margin account, contact your brokerage and ask directly 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 margin accounts; practices vary. Other firms run “fully paid lending programs” where you knowingly agree to lend shares in exchange for a share of the lending revenue, typically around 50% of the interest earned. If you join one of these, you’re accepting an ordinary-rate substitute payment plus lending income in place of a qualified dividend. Run the numbers on your specific positions before enrolling, because the lending revenue may not cover the extra tax.
A practical compromise for investors who want margin available for some positions: keep high-dividend holdings, where the qualified rate matters most, in a cash account or an IRA, and use the margin account for positions with little or no dividend yield.