Fooled by Dividends

TAXATION

The focus here is on dividend taxation, and how a large number of shareholders are not well-served by dividend payouts.  Under current tax law, net profits paid out as dividends are taxed at a rate of anywhere from 21% to over 85%, depending on the shareholder's taxable income.  We will address some of the other tax brackets below.  But, what we want to highlight here is the jaw-dropping effective tax rates that many in the upper-income brackets with ordinary dividends face.  This discussion is especially pertinent to the continual debate about taxing dividends as ordinary income.  We hope the reader remembers to point out the folly of that argument at the next opportunity.

Ordinary Dividends are taxed as ordinary income, at the taxpayer's marginal income tax rate (up to 37% federal).  In addition, the Affordable Care Act ("Obamacare", or ACA) has added a new "net investment income" tax of 3.8% for taxpayers earning more than $200k ($250k, married filing jointly).  So, we're now up to 40.8% federal tax on dividends, at the personal level, for upper-income taxpayers, and we're just getting started...

DOUBLE TAXATION

It is important to understand the concept that corporate taxes are paid by the shareholders.  Some view a corporation as some separate, faceless entity.  But, in reality, it is simply a collective of shareholders.  Every dollar spent is on behalf of, and comes out of the pockets of, the shareholders.  Any tax a corporation pays comes right out of shareholder equity; The tax is, indirectly, paid by the shareholder.  That is the concept of "double taxation", which few politicians understand or acknowledge.

Dividends are paid out of a corporation's net pre-tax income, after all deductions.  That means that every dividend dollar paid is subject to the corporate tax.  Almost universally, that tax rate is 21%, federal.  That is IN ADDITION to the personal income taxes paid by the receiver of the dividend (the shareholder).  So, now, out of a dollar paid to an upper-income shareholder, the federal government has taken 61.8 cents.  But wait, there's more...

TRIPLE and QUADRUPLE TAXATION

61.8% taxation?  No, we're not done yet.  In most states, that dividend is subject to state income tax.  In California, for example, that dividend is taxed at up to 13.3% for upper-income taxpayers, at the personal level.

And, each shareholder must also pay the state corporate income tax.  For a California corporation (AAPL, for example), the corporate state income tax is 8.84% (10.84% for banks and other financial institutions!).  Are you a high-income California resident who is happy to have received a nice dividend check from Apple?  Guess what?  The governments, state and federal, took all of it!  You should demand better from Apple's board of directors.  Surely they can find a better use for the money than to force you to send it to the government.

Do you think the Apple board of directors understand what they're essentially doing when they send out a dividend?  True, many shareholders are not in the upper tax bracket, and we address those below.  But, there are still many shareholders who get their dividends nearly taxed away.  That's insanity.

Remember this concept of double-taxation the next time you hear someone argue that dividends should be taxed as ordinary income.  That person needs to be educated on the extreme taxation dividends ultimately receive.  We should not allow the governments to take 84% of corporate profits.

It is absurd to think that a government will spend the dollar more efficiently than a profitable corporation, or shareholder.  Thus, it is highly inefficient use of funds.

ALTERNATIVES

If a corporation retains its earnings, without paying a dividend, it (you, as a shareholder) pays Uncle Sam 21 cents of every dollar.  It (you) has the remaining 79 cents to do acquisitions, buybacks, capital investments, etc.  All are great uses for the cash (especially for a profitable corporation), and growth-creating.

According to Standard and Poors, the current Price-to-Book-Value of the S&P 500 is 3.39.  That means for the typical company, a dollar kept by the corporation should eventually add $3.39 to shareholder value, if the company can use that dollar to grow earnings at the current rate (Return on Equity).

If the corporation cannot find a better investment of the retained earnings, it should do a share buyback.  That immediately increases the share price by the same per-share amount invested, without additional taxation.  Plus, it signals to the market that the board of directors believes the company is a better investment than others, and should help bring in new investors, driving the share price even higher.

Another example

If the above was confusing, let's look at this from another angle to prove the point...

GIVEN: ABC Bank of California finishes the year with $10000 per share in assets, and a net profit of $1000/share.  You are a California-resident shareholder in the upper income bracket, with stock held in normal (non-retirement) investment account.

Situation A: Corporation pays no dividend.  Corporation (you, as shareholder) pays Uncle Sam $210 in federal corporate income tax.  Corporation (you, as shareholder) pays 10.84% to California as state corporate income tax, for another $108.40.  Shareholder ends up with $9541.60 in asset share valuation, after taxes.  Corporation keeps remaining profit to invest in acquisitions, growth, buybacks, etc.  Summary: Your after-tax assets: $9681.60, Governments: $318.40.

Situation B: Corporation pays the $1000 as a dividend.  Corporation (you, as shareholder) still pays $318.40 to the governments.  So, after paying the dividends, the corporation's net assets are now $8681.60.  You, as a top-earner, must pay personal income tax on that $1000: 37% + 3.8% to Uncle Sam, 13.3% to CA, for a total of 54.1% (Govts: $541.  You keep, personally: $459).  Summary:  Your after-tax assets: $9140.60.  The governments took $859.40. 

Of the dividend paid, the governments got 85.94%!  The shareholder ended up with very little increase in wealth after the dividend.  And, the corporation ended up with less cash available for its capital requirements.  That's bad for the corporation, and not very helpful for the shareholder.

THE GOVERNMENT EVENTUALLY GETS IT ALL

There is a hole in the argument...  Let's ignore any Price-to-Book or Price-to-Earnings multiples for a moment.  In Situation A, the shareholder has a stock worth $1000 more than in situation B.  It has $1000 more in assets.  Eventually, the shareholder will have to pay capital gains taxes on that, when he or she sells.  So, eventually, the government may get the other $541.  But the corporation, which has already proven itself as profitable, will get to invest the money in the meantime, growing it exponentially.  That is a far better use of the capital from the shareholder's perspective.  Plus, those gains, if held longer than one year, would become long-term capital gains, and be taxed at a lower rate, comparable to the Qualified Dividends rate.  And, we cannot really ignore the Price-to-Book or Price-to-Earnings multiples, or Return on Equity.  A growing, profitable company should be able to grow that excess capital into for more than the dividend amount, benefitting all, including the governments.  And, the shareholder can choose the timing of the sale, better suiting his or her needs.  If the shareholder needs the cash flow the dividend intends, he or she can always sell a few shares to get the cash.

By the way, the "hole in the argument" part above explains how capital gains are also double-taxed.  Many people argue that capital gains and dividends should be taxed as personal income.  They need to be educated that the shareholder already paid tax on that money at the corporate level.

To anyone who will listen...  The next time you hear someone declare that corporate taxes are too low, or capital gains and dividends taxes are too low, please educate them.  Imagine how many jobs would be created (brought back from lower-taxed countries), if our governments stopped taking such a large cut of corporate profits.  Let those profitable companies expand!  (UPDATE: after this article was first published the federal corporate income tax rate has been decreased.)

And remember, the next time a corporate board declares a dividend, that it is a de facto admission that they can't think of a much better use of the money.  Is that really who you want running your corporation?  If you need income, you can always sell a few shares.

We'd love to hear your thoughts.

FAQs

Q)  What about a dividend recipient in the lower brackets?  Some lower-income shareholders are taxed at 0% at the federal level.  A)  True, but that is just the personal income tax portion.  Every dividend dollar is subject to the federal corporate income tax rate, at 21%.  So, 21% is the minimum taxation rate.  If the corporation or shareholder are subject to state income taxes, those rates are additional.  Many retirees fall into the lower brackets, but most dividend recipients are taxed at higher rates.

Q)  What about when the stocks are held in a tax-deferred account?  A)  Dividends paid into a tax-deferred account are taxed as ordinary personal income at withdrawal, with no special tax treatment.  That means that the governments will eventually get the remainder of their taxes, at the marginal rate of the retiree.  The total can still be over 85%.

Q)  What about those who receive the dividends as "Qualified Dividends"?  A)  The federal government has created a special class of dividends called Qualified Dividends, which are taxed at a lower rate (up to 20% federal, personal).  For a dividend to be "Qualified" for this special rate, there are a few requirements.  The main requirement is that the shareholder had owned the stock for 61 of the 121 days surrounding the ex-dividend date (60 days prior, 60 days after, inclusive).  For long-term investors, that is not a difficult requirement.  But for traders, or those who held the stock for fewer than 61 days during that period, the dividends are taxed as ordinary income, at their marginal rate.  A recent Forbes Magazine article repeated a statistic that the average holding period for SPY (the main ETF for the S&P 500) is just 5 days, so many SPY investors are paying their top marginal rate on dividend income.

So, for "Qualified Dividends", the top rate falls from 85.94% to 68.94%.  Still indefensible.

Q)  I am a middle-income shareholder in the 28% tax bracket, with no state income tax.  What is my effective dividend tax rate?  A)  If the dividends are "Qualified", the total rate becomes 36% (21% corporate, 15% personal), plus any state corporate income tax.  If the dividends are "Ordinary", or received into a tax-deferred account, the rate is 49% (21% corporate, 28% personal), plus state corporate income tax.  We still consider 36-49% tax rates too high, and a poor use of capital.

Q)  Aren't dividends a tax write off for the corporation?  A)  No.  Dividends are not deductible.  They are paid out of net income, after all deductions.  The corporation/shareholder pays the corporate tax rate on the earnings paid out as dividends.

Q)  Aren't dividends paid out of after-tax earnings, so that the total tax rate is less?  A)  No.  Dividends are fully taxed on both sides.  The calculations above are correct.

Q)  But the corporation pays income taxes on those earnings, whether they are paid out as dividends or retained.  Doesn't that make the true tax on dividends just the amount of the additional personal income taxes?  A)  No, that is not the proper perspective here.  In the ABC Bank example above, a dollar of earnings retained is taxed at 34.54%.  An earnings dollar paid out as a dividend is taxed at 85.94%.  You must separate the two.  In other words, the shareholder gets very little of the dollar the corporation earned to pay the dividend.

Q)  Aren't state income taxes deductible on a federal return, so that the total tax rate is less?  A)  Yes, in many cases.  We have excluded those calculations for simplicity.  The calculations above show the worst case, and can be trimmed by a few percentage points on various tax returns.  In all cases, the taxes are extreme.