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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.
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