Double Trouble
It’s time for a dividend strategy that incurs only one level of taxation.

Tom Nugent is Executive Vice President & Chief Investment Officer PlanMember Advisors, Inc.
January 29, 2002, 8:00 a.m.

any years ago Willie Sutton, a well-known bank robber, was asked: "Why do you rob banks?" His reply was: "That's where the money is!" A modern day Willie Sutton might be someone like Ralph Nader, a pugnacious, ex-presidential contender who just doesn't seem to appreciate the free-market system. If one were to ask him why he recently demanded that Microsoft pay cash dividends so that the government can get it's fair share of the taxes, Nader might also say: "That's where the money is!"

The absurdity of Mr. Nader's demand raises the question: Should a company be required to distribute dividends when it has accumulated cash, or should it adopt strategies that retain cash for pursuing the basic goal of corporate management — creating wealth for owners and shareholders?

To answer that, let's get some definitions out of the way. Cash dividends are the distribution of corporate earnings to shareholders — the basic reward for investing in a company. The disadvantage of paying cash to shareholders in the form of dividends is that such a payment makes little sense on an after-tax basis. For many shareholders, the taxation of dividends amounts to wealth confiscation. Corporate earnings are taxed twice, once at the corporate level and then again at the individual level. On average, when considering federal, state, and local taxes, one dollar of pre-tax corporate earnings becomes thirty cents of after-tax income for the owner (stockholder).

In other words, the stockholder's tax rate is approximately 70%! A majority of Americans believe that a 25% marginal tax rate is reasonable, so a 70% rate is obviously not reasonable.Consider the logic of the well-known practice of dividend reinvestment. Hundreds of companies have set up dividend-reinvestment plans for shareholders so that investors can reinvest in their business. Under this plan, the company retains the dividend and uses it for corporate purposes. The shareholder accumulates more shares in the company — but at the cost of paying taxes on the dividends. In one sense, a tax of 70% on a dollar of earnings distributed as a dividend gives the company only thirty cents to reinvest. If corporate management protected that dollar by investing on a pre-tax basis and avoided the payment of income taxes, the full dollar would be working for the company and the shareholder.

Numerous attempts have been made to reduce or eliminate the double taxation of dividends. However, many bureaucrats are not about to give up a lucrative source of tax revenue even though double taxation may be inconsistent with an equitable tax system. For taxable investors in mutual funds (the little guy), the problem is compounded by the treatment of realized capital gains. Each year, mutual funds must distribute to shareholders as dividends the net realized capital gains of the fund. These gains occur as portfolio managers sell stocks in the portfolio at a capital gain. As a result, shareholders may be faced with ordinary income taxes on the distribution of these gains if the stocks sold were held for less than one year. This problem is magnified by the possibility that new shareholders incur the taxes of old shareholders when the capital gains are distributed to new shareholders who did not benefit from them. To add insult to injury, mutual funds can't distribute capital losses that could be used to offset gains in other investments.

In a nutshell, cash dividends don't make sense for the following reasons:

1. They deplete corporate wealth and lower growth potential.

2. They can trigger the need for debt financing and subsequent interest payments.

3. They can be taxed as much as 70% when considering maximum federal and state taxes.

4. They allow no flexibility in the timing or payment of taxes owed on those dividends.

5. In uncertain times, the necessity of reducing or eliminating a cash dividend can have dire consequences for a company's common stock and ultimately for corporate management.

Given the disadvantage of inequitable tax treatment of cash dividends for taxable investors, and especially mutual-fund shareholders, the challenge for corporate management is to invent an alternative dividend strategy that has the following advantages:

Retains earnings for corporate use and minimizes the need for debt financing.

Maintains or even increases after-tax shareholder income without reducing corporate cash flow.

Provides the shareholder with flexibility in the realization of dividend income.

Reduces the amount of taxes paid on shareholder income.

Increases the possibility of higher stock-market valuation.

One strategy to accomplish these goals is to eliminate cash dividends and substitute a quarterly stock dividend. An important advantage of a stock dividend is that it is not taxed to the shareholder as a cash dividend. This advantage allows the shareholder to retain the additional stock with no current tax liabilities. The shareholder also can sell the new shares to produce current income. If the original stock were held for more than one year, the tax liability drops from the ordinary income-tax rate to the capital-gains tax rate. For taxable investors in the highest federal income tax bracket who sell shares held over one year, such a dividend strategy would substantially increase after-tax cash flow. Historically, this strategy might have been expensive when share sales incurred substantial transaction fees. In today's world of $5.00-$10.00 (or even zero) commissions per security transaction, the cost of selling stock are minimal.

In most cases an equivalent amount of pre-tax income derived from the sale of a stock dividend will be substantially more than a cash dividend on an after-tax basis because each distribution is taxed at different rates. The cash dividend is taxed at ordinary income-tax rates while stock dividends can be taxed at less than capital-gains rates that are much lower than ordinary income-tax rates. The only time when this advantage is not present is if the stock being sold has been held for less than one year. In such circumstances, the stock dividend is taxed (at most) as ordinary income if sold.

By choosing the stock-dividend alternative over the cash dividend, the company is increasing shareholder wealth on an after-tax basis. For shareholders who recoil from selling stock because they believe they should never "touch" their principal, there must be the realization that, for a taxable investor, there is an important difference in a dollar of principal and a dollar of income. If the choice is available, taking a dollar of principal is more valuable than taking a dollar of income because of the substantial tax consequences of the latter. Selling small pieces of principal to satisfy income is a viable investment strategy — especially for shareholders in the highest tax bracket.

If corporate management were to substitute a stock dividend for a cash dividend, there could be a dramatic improvement in the wealth accumulation for juveniles who save. In some cases, where juveniles must pay taxes on income at the parent's maximum rate, a dividend-reinvestment program, or even investing in dividend-paying stocks in a child's savings account, doesn't make a lot of sense. If a corporation replaced the cash dividend with a stock dividend, the individual or child would have no tax liability on that distribution. Furthermore, when the child needed money from that account at some future time for school or other expense, the total tax liability could be, at most, at a capital-gains tax rate — a rate that is [likely to be] lower than the ordinary income tax rate. In the meantime, that money would be growing tax free as opposed to the taxation imposed on quarterly cash dividend payments. By implementing a stock-dividend policy, a company could also reduce the necessity of debt financing and the related cash-flow drain of interest payments.

Every corporation that pays a cash dividend should consider substituting an optional stock-dividend policy simply because it makes common sense for both the company and the shareholder. In the year 2000, corporate America distributed $342 billion in dividends. By restructuring dividend strategy through the introduction of stock dividends, corporations can increase the distribution of corporate wealth to shareholders and keep more corporate wealth too!

During these difficult economic times, corporations can refurbish their balance sheets and improve retained earnings with little if any financial fallout. The only loser in such a strategy is the tax collector who takes an enormous share of corporate and shareholder wealth through the double taxation of dividends. It's time to give taxpayers a break by adopting a dividend strategy that incurs only one level of taxation.

At last count, Microsoft Corp. had accumulated over $36 billion in cash as a result of great products and broad consumer support. The company owes it to their shareholders to invest that money to keep the company growing. To satisfy the income needs of some Microsoft shareholders, the implementation of a stock dividend could be the right corporate strategy. Stunting corporate growth by paying cash dividends is senseless — especially for companies like Microsoft that have above-average growth prospects.