The proposed elimination of double taxation on dividends has got many a client and advisor alike wondering: “Should I dump munis and start loading up on dividend-generating stocks?” The prudent financial advisor's response should be, “Not yet.”
For starters, the dividend-excluding portion of President Bush's $670 billion tax cut plan is far from a slam dunk. Indeed, according to a recent New York Times editorial, “Even many of [Bush's] loyal supporters have declared [the elimination of dividend taxes] dead on arrival.”
Even if the proposal survives, an abrupt rebalancing of a portfolio to include more dividend-paying stocks is dangerous. Why? Because in doing so, you run the risk of unwittingly increasing a portfolio's exposure to stock market risk. The danger is that your client could walk in one day and say, “I want Altria [formerly called Philip Morris and yielding a mouth-watering 6.67 percent] and reduce my exposure to those stupid low-yielding New York City Health and Hospitals Corp. bonds yielding 4.875 percent.” Could happen.
Further, clients will likely want you to sell many non-dividend-paying stocks and, of course, that might touch off some capital gains taxes.
The best way to make sure your clients aren't burned in the coming months is to make sure you understand the particulars of the proposal and the tax implications — if it passes.
As the tax laws currently stand, corporate earnings are subject to two levels of taxation — one at the corporate and one at the shareholder level. Income earned by a corporation generally is taxed at 35 percent. When the corporation distributes earnings to shareholders in the form of dividends, that income is taxed again at an investor's personal rate, which can be as high as 38.6 percent.
The new tax plan would eliminate this double taxation by exempting qualifying shareholder dividends from federal income tax.
But, if the president's proposal passes, corporations will continue to calculate and pay income tax under the existing rules. They will then establish an excludable dividend account, or EDA, to house the funds they will distribute to shareholders. The EDA would increase in concert with the taxing of the corporation's income and would decrease on the occasion of the distribution or deemed distribution of dividends. Only distributions equal to the amount in the EDA would be excludable; distributions in excess of the EDA would constitute fully taxable dividends.
In addition, it's important to note that the EDA computation for the calendar year is generally based on the U.S. income tax return filed during the prior year. This translates into a one-year “delay” before earnings can be distributed to shareholders' in the form of excludable dividends. The President's proposal would apply to dividends paid on or after January 1, 2003 from corporate profits booked at 2001.
Firms that choose to retain and reinvest earnings instead of paying dividends would pass through an adjustment — called a deemed distribution — to the basis of stock held by shareholders. This would reflect the taxable income retained by the corporation. The increase in basis of the shareholder's stock would in turn reduce the capital gains taxes paid when the stock is sold.
Corporations that retain fully taxed earnings would not be required to pay these earnings as dividends in order for their shareholders to take advantage of the proposed exclusion. Rather, these corporations could declare dividends deemed to be paid from the EDA. This approach, sometimes referred to as a dividend reinvestment program, or DRIP, allows the tax-free roll-up of excludable earnings. The effect of a deemed dividend is to increase shareholders' tax basis in their stock and therefore reduce the capital gains upon a sale, as well as to lower a corporation's EDA by an identical amount.
All individual shareholders would be allowed to either exclude dividends distributed or increase their stock basis for “deemed dividends.”
There are a number of ways this proposal can affect your clients. At the very least, it will increase the amount of paperwork associated with their taxes, since they'll need to keep track of increases and decreases in the basis amount.
Until we see the fate of the dividend proposal, it's best to advise clients to stay the course.
Susan L. Hirshman is vice president at JPMorgan Fleming Asset Management. ipmorganfleming.com