Can someone explain to me why the new tax law is structured so that payments in lieu of ordinary dividends do not get the same favorable tax treatment? For the life of me, it makes no sense whatsoever. If you have street name shares in a margin account at a brokerage, they can and do hypothecate your shares to short sellers. Now the brokerages have to keep track of whose shares were lent out and divide up the 1099-DIV in sections indicating whether or not you received ordinary dividends or payment in lieu from the party who has borrowed your shares. What madness. I guess the only way to ensure you get ordinary dividends is to instruct your broker to park those shares in a cash account. The only positive I see is that this accounting/tax quirk may drive the market higher if the shorts are pressured to buy back in simply because the lenders want ordinary dividends vs payment in lieu. Simply ridiculous.
I'll take a guess. Suppose a company has 1000 shares outstanding and is paying a dividend of $1 per share. All 1000 shares have been borrowed to sell short. Now dividends will be received by holders of 2000 shares (1000 paid by the company and 1000 paid by the short sellers). This would result in $2000 of dividends subject to favorable tax treatment versus the correct amount of $1000. There's a partial offset as the short sellers will have reduced profit when they buy back the shares. But this is subject to capital gains treatment (which might be at the ordinary tax rate) and is recognized at completion of the transaction rather then when it is paid. As I said, just a guess.