Auditor Independence Redux

TAXATION

Federal Taxation

Tax Strategies for Tax-Advantaged Dividends and Capital Gains

By James G.S. Yang and Chiaho Chang

The Jobs and Growth Tax Relief Reconciliation Act of 2003 reduces the federal tax rates for dividends and long-term capital gains The changes brought about by the act will significantly affect investment and related tax strategies.

Dividends Tax Rate

Dividends received from corporate stock between January 1, 2003, and December 31, 2008, are taxed at a rate of 15% for individual taxpayers above the 15% tax bracket. For the individual taxpayers in the 15% and 10% brackets, the tax rate is 5% for dividends received between January 1, 2003, and December 31, 2007, and 0% for dividends received in 2008. All these rates will sunset after December 31, 2008, and the old rates, with a maximum of 35%, will return.

Dividends must be paid out of a corporation’s earnings and profits. The payment of federal income taxes on earnings is not a prerequisite for tax-advantaged dividends. Even if a corporation claims tax credits and pays no income tax, its stockholders can still enjoy low-tax dividends.

Because interest on bonds remains taxable to individuals as ordinary income at a maximum rate of 35%, an investment in stock may be a more attractive choice than an investment in bonds. This preference may lead to corporations raising more capital through equity funding than through debt funding.

Capital Gains Tax Rate

The long-term capital gains tax rate for investment assets held for more than one year is reduced, from the current maximum rate of 20%, to 15% for individual taxpayers above the 15% tax bracket for investment assets sold with payment received between May 6, 2003, and December 31, 2008. For individual taxpayers in the 15% and 10% brackets, the rate is 5% between May 6, 2003, and December 31, 2007, and 0% in 2008. Not all long-term capital gains are entitled to these reduced rates. Collectibles, such as artwork, antiques, stamps, coins, and silverwares, remain at a maximum rate of 28%. Unrecaptured IRC section 1250 gains on business long-term real property are also subject to a maximum tax rate of 25%. Short-term capital gains are not affected by the 2003 Tax Act and are still taxed as ordinary income, at a maximum rate of 35%.

On the other hand, capital losses, whether long-term or short-term, are still deductible up to $3,000 a year for individual taxpayers. Capital losses realized before May 6, 2003, can offset against capital gains realized after this date, but to maximize their benefit, such capital losses should be used to offset gains realized before this date (which would be taxed at the higher rate).

Choice Among Capital Loss, Capital Gain, and Dividend

Under the act, long-term capital gains and dividends are taxed at the same rate. Capital losses must offset against capital gains before they reduce ordinary income. Capital losses can fully offset all capital gains, but they can reduce ordinary income only up to $3,000 a year every year until they are fully exhausted. On the other hand, a dividend has no basis that can be reduced, nor can it be offset by capital losses. As a result, dividends will always result in a dividend tax.

From the above analysis, capital losses are most beneficial in sheltering income from taxes, and whether capital gains or dividends are preferable depends on the individual situation.

Capital Loss Bailout via Cash Dividends

If taxes on dividends are as low as 15%, and capital losses can save income tax at as much as 35%, connecting these transactions may result in tax benefits for the stockholders. From a corporation’s point of view, earnings increase its equity, but dividend distributions decrease it. From a stockholder’s point of view, a corporation’s earnings do not increase the adjusted basis in stock, while receipt of cash dividends represents taxable income. When a corporation distributes dividends, it is taxable at a lower rate to the stockholders, but it may lower the stock price. If a stockholder sells the stock shortly after the dividend date, it may result in a deductible capital loss that can offset ordinary income. In other words, the presence of tax-advantaged dividend creates an opportunity for stockholders to take advantage of the low-tax dividend and deductible capital loss.

The 2003 Tax Act imposes a waiting period of at least 61 days in the 120-day period surrounding the ex-dividend date. In order to maximize the benefits of short-term capital loss deduction, an investor may buy the stock 60 days before the ex-dividend date and sell the stock one day after the ex-dividend date, because the stock price will normally drop immediately after the ex-dividend date.

Dividend Versus Long-Term Capital Gain

Long-term capital gains can be delayed until the stock is sold. They can offset long-term or short-term capital losses that may result in no tax at all. Using long-term capital gains to save taxes is more flexible and versatile than dividend timing. If a corporation can convert dividends into a stockholder’s long-term capital gain, it may benefit stockholders. Whether dividends or long-term capital gains are ultimately more beneficial depends on the individual situation.

Example. H has been the sole stockholder of a corporation for several years, with $100,000 of adjusted basis in stock. The corporation now has $100,000 capital stock and $60,000 accumulated earnings and profits. Instead of receiving the $60,000 profits as a cash dividend, H sells all the stock for $160,000, realizing a long-term capital gain of $60,000 ($160,000 price – $100,000 adjusted basis). H also has $60,000 of capital loss from other transactions, which he uses to offset the gain. Had the corporation distributed the $60,000 profits as cash dividend to H, he would have paid a dividend tax of $9,000. H also can deduct $3,000 of long-term capital losses from ordinary income, saving income tax of $1,050, assuming a 35% rate.

In this example, the tax advantage for the current year is $7,950. On the other hand, by selling the stock, H has sacrificed the benefits of tax savings in the future by $21,000 ($60,000 capital losses ¥ 35% assumed individual maximum tax rate) if there is ordinary income to offset. Long-term capital gains can be more beneficial than cash dividends when there will not be ordinary income in the future to offset the capital losses.

Assume that the corporation has only $6,000 of accumulated earnings and profits. H sells all the stock for $106,000, realizing a long-term capital gain of $6,000. If this is then offset by a $6,000 of long-term capital loss from other transactions, H will pay no income tax. H’s dividend tax is $900 ($6,000 dividend x15% tax rate), but $3,000 of the long-term capital loss reduces ordinary income, saving income tax of $1,050 ($3,000 capital loss x 35% assumed maximum individual tax rate). The net tax savings are $150 ($1,050 tax savings on capital loss – $900 dividend tax). Moreover, there remains an unused capital loss of $3,000. In this case, a cash dividend would be more beneficial than long-term capital gain.

The examples illustrate that whether a long-term capital gain or a cash dividend is more beneficial depends on the amounts of capital loss, capital gain, and cash dividend.

Dividend Versus Short-Term Capital Gain

Short-term capital gains are taxed at as high as 35%, while dividends are taxed at as low as 15%. A corporation may be capable of turning what would be short-term gains into a dividend, yielding a tax savings for the recipient. For example, Tom is the sole owner of his corporation having an adjusted basis of $100,000. The corporation has $100,000 capital plus $10,000 earnings and profit. If after 11 months Tom sells the corporation for $110,000, he will realize a short-term capital gain of $10,000, resulting in a short-term capital gain tax of $3,500 ($10,000 short-term capital gain ¥ 35% ordinary tax rate). If Tom intentionally distributes the $10,000 earnings and profit as a dividend to himself, this will result in a dividend tax of only $1,500 ($10,000 dividend x 15% dividend tax rate), for a savings of $2,000.

Shifting Gains and Losses Between Corporation and Stockholder

The stockholder and corporation may coordinate through various permissible strategies to maximize tax savings by shifting gains and losses between them. Because the corporate income tax rate is higher than the individual long-term capital gain tax rate, it is more beneficial for the corporation to deduct capital losses. Long-term capital gains taxes are better paid by individual stockholders. For example, under current law, if the stockholder owns at least 80% of the corporation, the capital gain on IRC section 351 property contributed by the stockholder is shifted to the corporation. In the case of capital loss, IRC section 351 requires recognition by the corporation, regardless of the ownership position. Therefore, it would be more beneficial for a stockholder to contribute a property having a capital loss. If the property has incurred a long-term capital gain, however, it is much better for the stockholder to sell it, pay the capital gains tax, and then contribute the net proceeds to the corporation.

Example. E has equipment with an adjusted basis of $10,000 and a current fair market price of $9,000. If E contributes this equipment to the corporation, which sells it at a capital loss of $1,000, the corporation would save $350 in taxes ($1,000 capital loss x 35% tax rate), resulting in a net cash proceeds of $9,350. On the other hand, if E sells this equipment, a long-term capital loss of $1,000 is recognized. If this loss offsets a long-term capital gain, the income tax savings would be only $150 ($1,000 x 15% long-term capital gain tax rate). The net cash proceeds would be $9,150 ($9,000 price + $150 tax savings to the corporation), $200 less than if the property was contributed and sold.

Under the act, the individual long-term capital gain tax rate is as low as 15% for ordinary taxpayers, while the corporate income tax rate is as high as 35%, a 20% difference. Before the act, the tax benefits were only 15% (35% maximum corporate tax rate – 20% long-term capital gain tax rate).

Capital Gain Bailout via Treasury Stock

Before the 2003 Tax Act, when the dividend tax rate was as high as 38.6%, versus a long-term capital gain tax rate as low as 20%, there was a great desire to convert dividends to long-term capital gain. One possible alternative was the treasury stock approach. A corporation may purchase its stock back, consequently driving up the stock’s price. The stockholders may sell the stock, realizing a long-term capital gain. If there is no capital loss, the tax rate is reduced by 18.6% (38.6% – 20%). The stockholders still receive cash, but in the form of long-term capital gains, not a dividend. Under the act, the tax savings become zero (15% dividend tax rate – 15% long-term capital gain tax rate). The benefit of the treasury stock approach disappears. Worse yet, if there is any capital loss, capital losses must be offset against capital gains, not ordinary income (which would be more favorable). While the treasury stock approach may not be as beneficial under the act, in circumstances where the corporation does not want to distribute its earnings as cash dividends, or the stockholder has a large capital loss and there will be no future ordinary income to offset, then the treasury stock approach may be beneficial.

Example. R Corporation has 100,000 shares of common stock outstanding at a current market price of $100 per share. F owns 1,000 shares having an adjusted basis of $100 per share for two years. The corporation purchases 4,000 shares of its own common stock back, resulting in a price increase from $100 to $104. F sells the entire 10,000 shares at a price of $104, realizing a long-term capital gain of $4,000. F then uses this $4,000 of long-term capital gain to offset $4,000 of short-term capital loss. As a result, F pays no income on the long-term capital gain. This strategy is probably no more advantageous than other approaches. R Corporation does not have to erode accumulated earnings and profit to pay out the equivalent cash dividend. F also avoids the long-term capital gain tax of $600 ($4,000 long-term capital gain ¥ 15% tax rate) in the current year. But F may have sacrificed the benefits of deducting $3,000 of short-term capital loss in the current year and $1,000 in the following year against ordinary income, which could save as much as $1,400 in income taxes (assuming a 35% rate).

On the other hand, had the corporation distributed a $4,000 cash dividend to F, the cash dividend tax of $600 ($4,000 dividend x 15% tax rate), less the $1,050 tax savings from deducting a $3,000 of capital loss ($3,000 capital loss x 35% tax rate), would have netted a tax savings of $450.

James G.S. Yang, ABD, CMA, CPA, is a professor of accounting, and Chiaho Chang, PhD, is an assistant professor of accounting, both at Montclair State University, New Jersey.