Forbes.com has an article "Forget Dividends Go for Taxpaying Companies" has an article out today explaining that there is a feature in the proposal that allows firms to raise the shareholder's basis in the stock if investments from retained earnings are used rather than debt. This essentially allows tax deductibility of equity financing and therefore treats it comparably with debt. This is quite similar to the "deductibility of dividends" to the company proposal. The interesting feature is that this tax free distribution of internal financing is only available if the firm pays taxes and is reduced as firms reduce their tax liability with options and so on.
Business In The Beltway
Forget Dividends, Go For Tax-Paying Companies
Janet Novack, 01.07.03, 7:10 PM ET
WASHINGTON - There's a pleasant surprise for all stock investors hidden in President George W. Bush's proposal to end the double taxation of corporate dividends.
You don't have to own shares in dividend-paying stocks to get a piece of this new tax break. Here's why: In the Bush proposal, whatever amount a company is eligible to distribute to shareholders as tax-free dividends each year, it can instead reinvest and add to each shareholder's basis in the stock.
So if a company has $1 per share of earnings eligible for distribution as tax-free dividends, it can either pay $1 in tax-free income to shareholders or reinvest the cash itself and add $1 to each shareholder's basis in the stock, or pay out part as a dividend and add part to each shareholder's basis.
Say you buy a stock for $20, and the company reinvests $1 per share of eligible earnings each year. At the end of ten years, your basis is $30. If you sell at $40, you pay a maximum 18% capital gains tax on only $10 in gain. (The 18% rate is for stocks acquired in 2001 or later and held more than five years).
Before you start celebrating, be aware of two big catches.
A company's earnings are only eligible for tax-free distribution to the extent that the company actually paid taxes to the Internal Revenue Service the year before. So if you own shares in a company that generates lots of cash but pays little to the IRS--say, because it issues a lot of stock options, claims a lot of tax credits or makes aggressive use of dicey tax shelters--you may not benefit.
This is highly significant because, in recent years, the gap between what companies report as earnings to shareholders and the lesser amount they report to the IRS has become a chasm. The Bush plan wisely makes a point of only rewarding the shareholders of companies who actually are forking over some cash to the Treasury. The object is to eliminate the double taxation of earnings at the corporate and then the individual level--not to make them tax-free at any level.
The Treasury has come up with a formula to do this, and a Treasury official provided an example to Forbes of the results it produces. Company A has $100 in earnings and pays the IRS $35 in 2002 at the full 35% corporate tax rate. In 2003, it may distribute $65 to its shareholders as tax-free dividends or add $65 to their basis in the stock, or distribute part and add part to their basis.
Company B also has $100 of earnings but, because of its aggressive use of preferences and credits, only pays the Treasury $20 in 2002. In 2003, it can only distribute $37.14 in tax-free dividends and basis additions.
What's the second big catch? Neither the tax-free dividends nor the increase in basis will help you directly if you hold your shares in a tax-deferred retirement account, such as a regular IRA or 401(k). In that case, any income you eventually withdraw (and the law does force some withdrawals eventually) is taxed at an ordinary income rate of as high as 38.6% under current law. (The Bush plan would move that rate down to 35%, beginning this year.) Any retirement withdrawals from a Roth IRA are, of course, already tax-free.
If the Bush plan passes, it will make sense for investors to stuff their taxable bonds in their tax-deferred retirement accounts, while holding their stocks and stock funds in taxable accounts. And it will also pay investors to read the tax footnotes in a company's financial reports.
forbes.com |
