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Dividend Repeal Proposal

President Bush's proposed repeal of the dividend tax is major news for family businesses operating as regular (also known as C ) corporations. It's a yawner for many, because the majority of you are organized as non-taxable Subchapter S corporations, partnerships or LLCs.

Or, is it? Whether or not enacted, and regardless of your form of business, the proposal might have dramatic impact far beyond the headline issue of the double taxation of corporate earnings.

Background Distortions

Proposals to eliminate double taxation are not new. Treasury Department studies as recently as 1992 recommended integrating the corporate and individual income tax systems. Many economists believe that taxing earnings to the corporation and, subsequently, to its shareholders as dividends causes economic and other distortions.

Maybe so, but they are our economic distortions and it might be painful to live without them! Family business leaders would loose a primary rationale for not paying dividends the dividend tax.

The President stated that taking away the tax barrier to paying dividends will increase management accountability. No longer can corporate managers argue that it is more tax efficient for them to retain and reinvest earnings than to pay dividends to allow shareholders to make their own investment decisions. Might this change the dynamics in your next family shareholder meeting?

The Details

In a rather unusual move, the Treasury Department released additional details a few weeks after the initial proposal, although many aspects still must be worked out. A new alphabet soup of acronyms is required to determine how much a corporation can pay out tax-free, but a children's rhyme to the tune of the Hokey Pokey might help your understanding:

 

Divide your last year's tax bill As shown on the corporate return, By 35%, regardless what you earned. Take the taxes back out, Then shake them all about, And that's what the corp. can payout!

The concept is simple, although the implementation promises to be a boon to accountants, a needy constituency in this post-Enron era. Make no mistake, both the corporation and the shareholders will have massive new recordkeeping requirements.

The tax repeal would be effective for dividends paid in 2003 or later, but only out of post-2000 C corporation earnings. Pre-2001 earnings would still be taxed when paid as dividends.

The proposal clearly would reduce the need for schemes to extract tax-deductible income for the shareholders. You could simply pay a tax-free dividend, rather than having shareholders lease buildings and equipment to the corporation or resorting to possibly excessive compensation payments. Of course, you still might need these tax subterfuges if the current recipients own stock in different proportions from their sharing in the arrangements.

The dreaded accumulated earnings and personal holding company penalty taxes would be repealed. Although the IRS rarely asserts them, there is a little nostalgia here for me, since I wrote my Masters degree paper on the accumulated earnings tax 25 years ago.

S Corporation Similarities

Everyone knows that Subchapter S corporations generally pay no income tax. Instead, the shareholders pay tax on the corporation's income each year. The income can be distributed currently or in the future, with no additional tax. Any undistributed income adds to the shareholders basis in their stock, which reduces taxable gain when they later sell.

Under Bush's proposal, C corporations would pay the tax on their income each year, but shareholders would not pay tax again when it's distributed to them. Like an S corporation, undistributed income adds to the shareholders basis in their stock, thereby reducing capital gain when the stock is sold.

Either way, there is only one tax. However, the corporate and individual tax rates could be different. There also are likely to be numerous subtleties that could make one or the other form of taxation better, so it's premature to say whether an S or a C corporation will be best for family businesses. Any C corporation advantage might have to be pretty decisive because one might wonder whether Congress will be able to resist the temptation to add dividends back to the tax menu at some future point.

Electing S corporation status for the first time would be far less costly. The built-in gains tax (also known as the BIG tax ) is a corporate level tax assessed on LIFO inventory reserves and gain recognized on assets sold within 10 years of the election. The shareholders also are taxed on these items. Under the President's proposal, there would be no shareholder tax.

Investors Beware

Investment pundits are already having a field day recommending changes to your investment portfolio. I'm hearing and reading things like:

 

  • Municipal bond yields will have to go up because they must compete with tax-free dividends on publicly traded stocks.
  • Buy value stocks and sell growth stocks. The former pay higher dividends that will be tax-free, while you'll have to pay capital gains tax when you sell low- or no- dividend growth stocks.
  • Management fees in high cost mutual funds effectively may not be deductible because they can no longer be directly offset against the funds dividend income. So, buy index funds because their fees are low.

You should view these types of advice with skepticism. They inevitably ignore or assume away a variety of considerations that may be far more significant than the tax law change.

Legislative Prospects

With mounting federal and state budget deficits, ferocious Democratic resistance, shaky Republican support, plus war and terrorism concerns, the odds of Bush's proposal passing intact are rather slim. At a minimum, the President likely will have to make numerous, substantial political trade-offs. Probably only his closest advisors and Congressional leadership know what he might choose to concede in order to garner the necessary political support.

It was interesting that early rumors about his proposals contained a 50% dividend exclusion. Perhaps he increased the proposal to 100% exclusion so that he could compromise at 50%. That seems too easy. On the other hand, if simplicity ever caught on, a straight 50% exclusion, with none of the current proposal's complexity, could be a great compromise.

He also proposes to make permanent the 2001 Tax Act provisions that are scheduled to expire after 2010. In other words, he proposes to permanently repeal the estate tax. As the Democrats quietly observe that both dividend and estate tax repeal only benefit the wealthy, which way might the horse trading go?

The inevitable trade-offs necessary to accomplish such major reform as eliminating the dividend tax will affect all of us. For better or for worse, this spring and summer promise to be exciting times on Capitol Hill.

 

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