Question: Is early payment of dividends an effective way of avoiding the tax due to the fiscal cliff?

Bull's Response
There's really only one fundamental reason for publicly-traded companies to exist - to pool capital from shareholders, invest it in projects that generate positive net economic returns on that capital and return the capital to shareholders. Whatever legal moves a company can take to maximize the value of the capital they return to shareholders is, on balance, a good thing.

So too with the recent spate of special dividends and accelerate dividend payment schedules in light of the potential tax ramifications of the fiscal cliff.

Guide To Oil And Gas Plays: We've got your comprehensive guide to oil and gas shales in North America.

And Here Come the Pretzels ...
In recent weeks, over 120 companies (according to Markit) have announced special dividends - well ahead of the usual seasonal trend in such announcements. At the same time, many companies that are not paying special dividends are at least goosing up their payment schedules such that the dividends are paid in the 2012 tax year, due to real world factors affecting dividend taxes.

Perhaps the biggest example of this calendar gerrymandering is Oracle (Nasdaq:ORCL) - the tech giant is pushing its next three quarterly dividend payments into December, saving Oracle co-founder Larry Ellison (and owner of roughly one-quarter of the shares) potentially tens of millions in higher taxes on those dividends. But it's not just Oracle - companies as diverse as Disney (NYSE:DIS), Walmart (NYSE:WMT) and HCA Holdings (NYSE:HCA) are likewise running ahead of the taxman.

Taxes Are Real
It's not hard for investors to find advice online telling them not to make decisions on the basis of taxes. While I can appreciate this advice in principle (I'd never recommend selling a winner just to get a slight edge on capital gains taxes, for instance), it doesn't hold up so well in practice.

The upcoming change in dividend taxation is not trivial - taxes on qualified dividends are going to move from 15% (for most investors) to an investor's ordinary income tax rate (over 39% at the high end), and a special additional 3.8% tax is going to be levied on some "high earners." Moreover, while it's true that a large percentage of U.S. equity is held by wealthier people, more than half of American families own stock and have more than one-third of their total financial assets in stocks.

As a result, I would argue that this significant change in the tax policy is adequate motivation for public companies to respond. In the case of Oracle, these dividends were almost certain to be paid anyway, so why not save investors a potentially meaningful amount of money and maximize the value of that returned capital? Sure, if you own 100 shares of Oracle and fit into the 28% bracket you are only talking about $2.34 of tax savings and that sounds trivial, but I suspect that if I put out the offer that anybody who doesn't want the $2 can just mail it on to me, I don't think I'll get many takers.

Special Dividends May Just Be Accelerating the Inevitable
It seems relatively easy to defend accelerated dividend payments. If the raison d'etre of public companies is to maximize the return of capital to shareholders (which it is) and those dividends were going to be paid anyway, shifting the schedule a few weeks to avoid the taxes is logical.

The case for the special dividends is a bit harder to make, but not impossible. The idea behind the special dividend payments is basically the same - companies have identified these amounts as surplus capital and see a means of returning it to shareholders at a lower tax rate. Companies do this sort of thing all the time; whenever there are tax breaks on repatriating capital, it comes flooding in from abroad, and likewise accelerated depreciation or tax credits reliably coax companies into adjusting their capital spending and allocation priorities.

Is this a good thing? On balance, probably not - companies should be in the business of their business, and not playing tag with the taxman. At the same time, the government created this mess all on their own and taxes are an economic signal like any other - if you make something more expensive (capital, in this case), independent economic agents are going to move to minimize the damage.

The Bottom Line
A cynical evaluation of history suggests at least a couple of companies are going to get themselves in trouble by paying too much out in these special dividends and will later have to turn to more expensive supplementary capital. That's really not a dividend timing or tax policy problem, though; rather, it's a case of poor planning and capital allocation, and odds are that the company(ies) in question would have made some other mistake with the capital independent of the fiscal cliff.

As it stands, these decisions to pay special dividends and/or accelerate dividend payments are a logical reaction to a significant oncoming change in U.S. tax rates. While it may be true that Congress will figure something out and work out a compromise that neutralizes or reverses the anticipated tax increases, it really doesn't change the math of these moves. At a bottom line net present value level, money received today is always more valuable than the same sum received tomorrow, so while these companies may or may not be saving their shareholders substantial sums in dividend taxes, they are at a minimum enhancing the net present value of that dividend stream by paying early.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

Don't forget to read the Bear side of this debate and weigh in with your opinion below.

Related Articles
  1. Stock Analysis

    3 Stocks that Are Top Bets for Retirement

    These three stocks are resilient, fundamentally sound and also pay generous dividends.
  2. Investing News

    Are Stocks Cheap Now? Nope. And Here's Why

    Are stocks cheap right now? Be wary of those who are telling you what you want to hear. Here's why.
  3. Investing News

    4 Value Stocks Worth Your Immediate Attention

    Here are four stocks that offer good value and will likely outperform the majority of stocks throughout the broader market over the next several years.
  4. Investing News

    These 3 High-Quality Stocks Are Dividend Royalty

    Here are three resilient, dividend-paying companies that may mitigate some worry in an uncertain investing environment.
  5. Stock Analysis

    An Auto Stock Alternative to Ford and GM

    If you're not sure where Ford and General Motors are going, you might want to look at this auto investment option instead.
  6. Mutual Funds & ETFs

    The 4 Best Buy-and-Hold ETFs

    Explore detailed analyses of the top buy-and-hold exchange traded funds, and learn about their characteristics, statistics and suitability.
  7. Mutual Funds & ETFs

    What Exactly Are Arbitrage Mutual Funds?

    Learn about arbitrage funds and how this type of investment generates profits by taking advantage of price differentials between the cash and futures markets.
  8. Investing News

    Ferrari’s IPO: Ready to Roll or Poor Timing?

    Will Ferrari's shares move fast off the line only to sputter later?
  9. Investing Basics

    3 Key Signs Of A Market Top

    When stocks rise or fall, the financial fate of investors change, as well. There are certain signs that can reveal a stock’s course, and investors don’t need to be experts to spot them.
  10. Stock Analysis

    5 Cheap Dividend Stocks for a Bear Market

    Here are five stocks that pay safe dividends and should be at least somewhat resilient to a bear market.
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  5. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!