Last year's dividend tax cut was meant to put more money into the hands of investors. But some investors who buy stocks with borrowed money have been left behind by the law.

A recent lawsuit alleges that

Merrill Lynch's

(MER)

margin policy is depriving some customers the benefit of last year's dividend tax cut. The putative class-action suit contends that some Merrill margin customers may be paying a higher tax rate because the dividends they receive aren't technically dividends under federal law.

The problem, the securities lawyers say, stems from the way Merrill and much of Wall Street traditionally has treated stock purchases by customers in a margin account. Most brokerages consider those shares to be a fungible commodity that can be lent out to another investor, usually some hedge fund, which pays interest to the broker.

Normally this arrangement of lending out another person's stock doesn't cause any problems, and most investors aren't even aware it's happening. But it can become an issue when a broker lends out shares of a dividend-paying stock. If those shares are out on loan during the time a company pays a dividend to its stockholders, brokers typically credit the account of the borrower, not the original customer.

To keep their margin customers happy, brokers usually make up for this lost income by making a substitute payment at a later date. From a practical standpoint, there's no difference between a substitute dividend and the real thing.

But last year's dividend tax cut, which reduced the tax rate on dividends to 15% from 35%, changed everything. That's because under federal law, substitute dividends are not entitled to the dividend tax break and are taxed as ordinary income, at rates as high as 35%.

In other words, the borrower gets the benefit of the tax cut, while the margin customer is looking at potentially paying more in taxes. It's a quirk that some say needs addressing either through the courts or by an amendment to the tax law.

"Individual investors may get screwed on taxes," says James Angel, a professor at Georgetown University's McDonough School of Business. "It's basically a problem with the law."

The securities lawyers say that until the law is changed, it's up to Wall Street to treat its customers fairly.

The lawyers bringing the Merrill suit have raised a similar allegation against

Pershing

, the stock clearing and brokerage arm of

Bank of New York

(BK) - Get Report

, in a separate lawsuit. And more lawsuits may be on the way.

"This is an industrywide problem," says Lawrence Sucharow, a partner with Goodkind Labaton Rudoff & Sucharow, one of the law firms filing the lawsuits.

Some Wall Street firms, realizing the obvious inequity of this situation, are voluntarily providing an additional payment to their margin customers to make up for the discrepancy. Three firms that have said they will take on this added obligation are

E*Trade

(ET) - Get Report

,

Morgan Stanley

(MWD)

and

Charles Schwab

(SCH)

, although Schwab notes on its Web site that this "discretionary payment" may be "discontinued at Schwab's discretion."

But other brokerages are silent on the issue of the dividend tax. The Merrill lawsuit contends that the firm's margin agreement "does not authorize, either expressly or impliedly, the Merrill Lynch dividend policy." Pershing's disclosure statement says, "We suggest you contact your tax adviser to discuss the tax treatment of substitute payments."

"We say it's an obligation of their relationship to provide this," says Sucharow.

Merrill Lynch spokesman Mark Herr says the lawsuit is without merit. He says the firm is "confident it has dealt with the issue appropriately," but he wouldn't elaborate. Pershing spokeswoman Barbara Gallo says the brokerage had no comment on the lawsuit, but she adds that Pershing is looking at ways to minimize the impact on its customers.

Sucharow says he is concerned, however, that firms that have decided to reimburse investors for the lost tax benefit could reverse course with little advance notice.

Indeed, at least one firm that has decided to provide a tax credit to its customers appears to have left the door open to the possibility that it may stop making the additional payments.

Shortly after the tax cut was enacted,

Fidelity Investments

, the brokerage arm of the mutual fund giant, revised its margin agreement to include cautionary language, warning investors "that substitute payments may not be afforded the same tax treatment as actual interest, dividends." The agreement also informs Fidelity customers that they "may incur additional tax liability for substitute payments."

But Vincent Loporchio, a Fidelity spokesman, says the firm intends to credit its customers for any excess taxes they are forced to pay despite the revised language in the agreement. The additional payments will be made in February, and Fidelity customers already have been told about the firm's plans.

"We have no plans to change the credit adjustment," Loporchio says.