Attn: The Corner Office – Why U.S. Firms Should Pay Special Dividends Before Year-End 2010

Now that the New Year has arrived, read an update from Dr. Briginshaw in the GBR blog!

URGENT MEMO

Attn: The Corner Office

Current low tax rates on dividends, combined with low borrowing costs, represent an historic opportunity for U.S. firms to:

1. Get funds into stockholders’ hands at low tax rates, which stockholders may then reinvest or spend.

2. Replace equity (at a cost of capital in excess of 10 percent) with debt (at a cost of capital at or below 5 percent).

3. Leverage up their businesses at low borrowing rates, to maximize interest tax-shield, drive increased efficiency, and position their stock for a period of sustained capital growth.

But the window is closing and dividend tax rates are almost certain to rise on December 31, 2010—possibly by as much as 160 percent.

Dividends: The Basics

Dividends are cash payments to a company’s stockholders out of current or retained earnings (accumulated surplus).  Once a dividend has been declared by a company, stockholders receive cash in proportion to their shareholding—and must pay tax on the dividends received. The effect on the company’s accounting is that assets (cash) and stockholders’ equity (retained earnings) decrease. A company’s board of directors has broad discretion to award dividends, provided the requirements of applicable state and federal law are met. In practice, this means that corporations with accumulated deficits (negative retained earnings on their balance sheet), or in situations where market value of assets is below debt outstanding, usually may not pay dividends.[1] Historically, dividends have accounted for the dominant part of the return on stocks.[2] As Chart 1 shows, dividend yields (defined as annual dividend divided by stock price) for index stocks have been declining over time (as stockholders hoped to rely on capital gains for more of their total returns), but likely changes in dividend tax rates from current levels of zero (for lower earners) to 15 percent (for higher earners), and the risk of excess cash being wasted by firms, suggest this should change. Some widely held dividend paying stocks are listed in Table 1.

Chart 1: Dividend Yield of S&P Composite Index (or Equivalent)

Table 1: Examples of high performing dividend paying stocks within the Dow Industrial Average

Current Zero to 15 Percent Dividend Tax Rates are an Historic Opportunity

Current tax rates on dividends in the U.S. of between zero and 15 percent are remarkably low, especially when compared with the past. Before 2000, dividends were taxed as ordinary income, attracting a maximum tax rate of 39.6 percent. The tax rate then eased slightly over 2001-2002, before falling to the current 15 percent level in 2003. However, since the U.S. has a “classical” tax system, the pre-2000 situation was even worse than the 39.6 percent rate suggests. Under a classical tax system, dividends are taxed twice, since they are paid out of (already taxed) net income. If $100 of pretax income is taxed at 35 percent corporate rate, this leaves $65 of net income or earnings. If a company had paid this entire $65 to a stockholder as dividend pre-2000, 39.6 percent of the $65 would have been taxed at the personal level, leaving a paltry $39.26 for the stockholder. This is an effective tax rate in excess of 60 percent on the original $100 of income, and this is before state taxes of as much as 10 percent.  However, the real question is—how will current dividend tax rates compare to the future?

Dividend Tax Rates Will Likely Go Up in Less than Three Months

It is highly likely that dividend tax rates will rise on December 31, 2010 for some or all taxpayers. The current tax rates are a product of the Jobs and Growth Tax Relief Reconciliation Act of 2003 and the Tax Increase Prevention and Reconciliation Act of 2005—nicknamed the “Bush tax cuts.” The latter act extended the dividend tax rates to the end of 2010, but at that time the tax cuts will “sunset” (expire) and rates will revert to the pre-2000 levels.

As this issue of the Graziadio Business Review goes to “press,” midterm Congressional elections are taking place, but these may have little effect, for three reasons. Firstly, the newly elected representatives will not take office until January 2011, leaving the “lame duck” 111th Congress as the only source of new law before the tax cuts actually expire—current Democratic party policy is to increase dividend taxes for high earners. Secondly, both parties, confronting horrific budget projections due to ballooning entitlement spending, have a hidden incentive to allow the tax cuts to expire. Thirdly, since the likely outcome of the election is to enhance the Republican position in both houses, the Republicans—looking forward to the 2012 Presidential vote—have a more obvious incentive to “reluctantly” fail to find common ground with the their Democratic colleagues come January 2011, fail to reverse the expiration of the tax cuts, and then try to stick the blame on Obama in November 2012 for the resulting $3-trillion tax raise.

This would mean that dividends will again be treated as ordinary income, resulting in an income tax rate of 39.6 percent for those at the top rate.  As The Wall Street Journal notes, in addition to the 39.6 percent rate, a Medicare supplement of 3.8 percent will also be payable by highest income taxpayers (effective 2013) to pay for the recent “Obamacare” healthcare changes.[3] This means an increase of 160 percent in the tax rate (or 189 percent including the Medicare levy). Obama has proposed that Congress instead adopt a 20 percent dividend rate (33 percent increase), but this has not been taken up by the 111th Congress, even though Democrats have majorities in both houses (albeit a narrow one in the Senate). The best case for stockholders might be for the Republicans to score enormous victories in November 2010 and feel a duty to act to decrease taxes. Looking at the Senate, 37 seats are up for election—34 due to the regular six-year cycle and three special elections.  Of those 37 seats, 19 are Democratic and 18 are Republican. Since the Republicans currently have 41 Senate seats, they must win all 19 Democratic seats to secure a filibuster-proof majority (required for them to take action without some Democratic support) of 60 seats in the Senate. Even if the Republicans did score a notable victory, unfunded tax cuts might run up against concerns that government live within its means, as advanced by the “Tea Party” movement and other groups.

Personal Tax Planning Considerations have Reversed and Corporate Borrowing is Accessible at Low Rates

In order to provide further support for the case for paying substantial dividends now, let us deal with the traditional arguments against such payments. Firstly, the tax-planning argument for deferring the recognition of income or gains is predicated on the likelihood of taxpayers facing lower income tax rates in retirement, due to lower incomes. This loses force for two reasons—firstly, the likely reversion of dividend tax rates to 39.6 percent in the short term and, secondly, the high probability of increases in tax rates in the medium term due to rising budget deficits. Because of the influence and voting power of older voters and the benefits they gain from entitlement programs, Congress is less likely to solve the spending problem than the revenue problem, although both are uncomfortable to confront (Congress may solve neither problem!). Taxpayers (and by extension, directors considering dividend levels) who rely on the traditional tax-planning view must reckon on tax liability being a combination of likely lower income levels in retirement, together with almost inevitably higher tax rates. Finally, low 401K balances for many U.S. workers  will necessitate longer working lives, thus decreasing the number of years where the putative lower incomes will occur.[4][5]

Secondly, the cash conservation and signaling arguments against paying large dividends are mitigated by the low interest rates, at which creditworthy firms can borrow and the alternative of characterizing the payments as special dividends. Firms may balk at paying out cash because they wish to maintain financial flexibility and to protect against the possibility of a liquidity crisis. However, with cash reserves at high levels (see Chart 2), low gearing ratios that suggest plenty of borrowing capacity (see Chart 3), and borrowing rates that are close to their lowest levels since records began, such firms can maintain financial flexibility by borrowing to fund the special dividends and adding additional borrowing to maintain flexibility and fund new projects (see [6] and Chart 4). Firms can also avoid signaling that the dividends will be continued in subsequent quarters by paying these dividends on non-standard dates and making clear in other ways that they are special dividends—one-off events in response to exceptional circumstances.

Chart 2: Cash as a Proportion of Total Assets for U.S. firms in the S&P Compustat Database

Chart 3: Debt divided by Equity for U.S. firms in the S&P Compustat Database

Chart 4: 30-year corporate (Baa rated) bond rates ( percent)

Paying Dividends is Good for Business

Funding large special dividends with borrowed cash has two positive effects on firms. Firstly, because interest payments are tax-deductible, it reduces the tax bill for firms. However, since dividends are taxable at a higher effective rate (being double taxed), this tax benefit does not of itself justify the transaction. However, other benefits occur when companies take on debt, as laid out in the Jensen “Free Cash Flow Hypothesis” proposed by Harvard Business School Professor Michael Jensen. Jensen hypothesized that firms with large amounts of free cash flow tend to waste it on unprofitable investments or even perks, such as company jets.[7] Debt payments tend to “tie managers’ hands” and force them to be more frugal, to the benefit of profitability. Also, a higher proportion of debt at current rates may decrease weighted average cost of capital, allowing firms to take on more marginal projects and make higher abnormal return from existing projects. This is due to the risk premium on corporate debt having fallen faster than the risk premium on equity (possibly due to a “bubble”” in debt values).[8]

Paying Dividends May Dominate Buybacks in this Environment

If companies wish to return resources to stockholders, stock buybacks or repurchases are both alternative methods to dividends. Buybacks have advantages over dividends in that stockholders who do not wish to receive any resources from the company—either for tax reasons or because they wish to maintain or roll-up their position in the stock—will not receive any benefit or tax liability until they sell. Also, stock buybacks have often been seen as a way of management showing confidence in their company, by buying when share prices are low.[9] However, the effectiveness of stock buybacks requires some current stockholders to sell at these “low” price levels—introducing a conflict between current and future stockholders: buybacks can be seen as slightly favoring future stockholders, whereas management is accountable (as agent) to all owners, not any one class. Also, as Warren Buffett has pointed out, stock option holders, including management, gain clear advantages from buybacks whereas they gain nothing from dividends—introducing a potential incentive for self-dealing in the timing of buybacks.[10] Furthermore, even if management does resist the temptation to self-deal in timing buybacks, they may be unable to successfully “time the market” with their buybacks. In the event that funds are used for buybacks and then the market for the stock falls (either due to company or market-wide factors), then those funds have not added any obvious value to the stockholder. Although, in the long term, buy-and-hold stockholders will gain from securing a larger share of corporate dividends and earnings, management and shorter time-horizon stockholders will see no immediate benefit and the cash will appear to have been wasted. This will tend to dissuade management from executing buybacks at times of market uncertainty, which is unfortunate because these may be times of opportunity and low stock prices. No such problems occur with dividends. Dividends benefit all stockholders equally, give no advantage to insiders and retain their value (once paid), irrespective of stock price moves. With the current (pre-December 31) tax structure and the uncertainty as to stock market direction, dividends are as attractive a method of returning funds as they have ever been. Stock buybacks certainly remain a useful tool in corporate finance and will have their time, but the time for dividends is now.

For Some Classes of Firms, Paying Dividends is Especially Attractive

Paying dividends now will be most attractive for companies that have lower institutional shareholdings, companies that have plans to pay dividends and have the resources to pay the dividends early, and closely-held C-corporations that have a business-related need to make distributions and that have exhausted more tax-efficient distribution avenues.

Institutional shareholdings include holdings in tax advantaged funds, such as 401Ks and IRAs—since dividend payments to these entities are tax sheltered or tax deferred, dividend tax rate does not have an obvious effect on wealth for holders of these funds. These stockholders will therefore be indifferent between receiving dividends now or later, and will not wish management to expend time on the issue. However, it should be noted that institutional shareholdings also include taxable mutual funds, ETFs, hedge funds, and corporate trading vehicles, all of which will be exposed to any change in tax rates.

There is a clear incentive for a firm planning to pay a dividend on January 1, 2011 to pay it instead on December 31, 2010, to ensure that the zero to 15 percent rate is applicable. However, for firms with a long established dividend policy, why not go further? The next three or more years of regular dividends could be rolled up into a special dividend, funded with cash reserves and (if needed) three-year bonds, which for AA-rated firms can be issued at less than 2 percent yield. This would be justifiable in a business sense, as it would constrain the firm’s management from un-needed spending in accordance with the Jensen “Free Cash Flow Hypothesis” discussed above. It would also  eliminate portions of the unproductive cash reserves that businesses are currently holding (see Figure 1). Finally, dividend paying firms will already have attracted a clientele of stockholders whose tax or other circumstances favor dividend payment.

The low dividend tax rates have long been thought of as advantageous for closely held C-corporations.[11] Also, in the past, the IRS has indirectly encouraged small firms to pay dividends by imposing an Accumulated Earnings Tax on retained earnings beyond the firm’s “reasonable needs.”[12] For these firms, if a distribution is being considered and makes sound business sense, now is the time. Closely held firms have an advantage over large public companies in that, while it is difficult for large firms to survey stockholders about whether dividends are attractive to them, closely held firms have a small shareholder base that enables them to do this. However, firms should not perform large dividend payments solely for tax reasons, and uneven usage of dividends versus traditional methods of compensation, such as bonuses, may not survive IRS scrutiny. Also, it should be noted that smaller closely held firms may have more difficulty in borrowing funds than large firms with high credit ratings, and thus may need to fund dividends with existing cash reserves.

While the Accumulated Earnings Tax (AET) is most often applied to small firms, is also applicable to public companies.[13] Note also that the AET rate tracks the tax rate on dividends. The IRS’ incentive to pursue public companies for AET will markedly increase if dividend tax rates rise. As can be seen from Chart 2, publicly traded companies are holding increased amounts of cash. One well-known example is Apple Inc., with cash and marketable securities of more than $40 billion.[14] Apple and other similar firms may be a tempting target for the IRS once tax rates have risen. In other words, companies that do not pay dividends (perhaps out of desire to avoid or postpone taxes), may be forced to disgorge the applicable tax anyway, and at a higher tax rate.

Note that, for S-corporations or for non-incorporated businesses reporting on IRS Schedule C, tax is on income, and distributions such as dividends do not affect tax. These businesses will not see any change in tax liability from the dividend tax increases.  Also, companies that have to repatriate cash from foreign subsidiaries to pay the dividends may have to pay additional taxes on the cash remitted to the U.S.[15]

Pay Dividends Now

Not paying dividends now shows admirable trust in our government to come up with a sensible solution to the problem of dividend tax rates. The best case is that the current dividend rate will persist. More likely, tax rates will rise for some or all taxpayers. And for dividend tax rates to rise by 160 percent, all Congress has to do is … well, nothing. Also, the option of waiting to pay dividends may not be available for long. Projected budget shortfalls and an increased rate of dividend tax (and therefore a higher rate of Accumulated Earnings Tax) will increase the incentive for the IRS to force payment of AET on company cash reserves where earnings have been retained beyond “reasonable needs.” U.S. businesses should anticipate the likely outcomes and, for the good of stockholders and their firms, pay substantial dividends now.

Many thanks to Professor Michael Kinsman, Professor Darrol Stanley and an anonymous reviewer for their helpful comments prior to the publication of this article.