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

Bear's Response
As the fiscal cliff draws near, a record number of American companies are paying special dividends before the end of 2012 to save shareholders from paying higher taxes. Other companies are moving regular dividend payments from early 2013 to the end of 2012 to do the same. The problem with this tactic is that it's a reactive move by CEOs to placate investors; it's not a rational decision about capital allocation. Ultimately, the government's going to get its pound of flesh whether or not special dividends are distributed to shareholders. This is a bad move; I'll explain why.

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Rite of Passage
I am a huge fan of special dividends. One of my favorite stocks of the past decade is Buckle (NYSE:BKE), a specialty retailer based in Kearney, Nebraska. In the past five years though (through to the end of 2012), Buckle will have distributed to shareholders $17 per share in dividends including $13.05 of the special variety. In what's become an annual rite of passage for the company, it announced in early November that this year's special dividend payment would be $4.50 per share, its highest ever. I'm sure CEO Dan Hirschfeld and the board considered the fiscal cliff discussions when determining the size of this year's dividend. However, its consistent actions demonstrate that special dividends are an important part of its capital allocation program. When a business articulates its spending plans as clearly as Buckle does, it's hard not to love it. Unfortunately, few do.

Everyone Is Doing It
Markit, a financial data company, predicts 123 companies will make special dividend payments in the fourth quarter compared to 31 in typical years. Three times as many companies are stepping up to the special dividend plate in 2012, an obvious move to ease the impending tax burden of its shareholders. Well-intentioned as they might be, this is another example of corporations throwing money at a problem instead of executing a long-term plan. Buckle, like other companies using special dividends responsibly, see them providing the ultimate flexibility for management. Paying a small quarterly dividend of 20 cents, which is approximately 25% of its earnings, it's able to preserve cash for future expansion, etc. However, by releasing a significant chunk of cash to shareholders towards the end of the year when holiday shopping is brisk and cash flow is high, it serves the dual purpose of rewarding shareholders while preventing the company from getting too flush with cash; eliminating the temptation to speed up or add to its store openings. Buckle is as conservative as they come.

Are We Paranoid?
The increase in fourth-quarter special dividend payments is a knee-jerk reaction by corporate boards to a situation that could unfold much differently than expected. It isn't a corporation's responsibility to consider a shareholder's tax situation when allocating capital. Besides, we don't even know yet who and how many will be affected in 2013 by the expiry of the Bush-era tax cuts, because a last minute fiscal-cliff resolution could include tax increases for just the top 2% of wage earners in the United States. And even if all the taxpayers get whacked, the ultimate sacrifice could be far less than we anticipate. The media has fixated on the top tax rate of 39.6%. But how many people earning dividends are in the highest bracket?

The Huffington Post, citing data from Markit (mentioned above), suggests American companies have paid out $24.2 billion in early or special dividends in 2012, saving its shareholders an estimated $6 billion in taxes. Forget for a moment that these companies whine and complain about the government debt and then initiate payments that directly affect the government's ability to reduce said debt. Talk about speaking out of both sides of their mouths. It's hypocrisy at its very best. The simple fact is that those earning less than $200,000 per year have traditionally received the lion's share of dividend payments made to individuals. In 2010, they received 46.6% of the total. While it's hard to know how many of that number skew closer to $200,000 rather than away from it, 48% of those receiving dividends are 65 or older and likely not in the top tax brackets. Parsimony Investment Research, points out that a retired couple earning $80,000 per year in dividend income would see their after-tax amount drop from $68,000 to $65,472, a 3.7% decrease. That's about $7 a day - I guess they'll have to forego their daily Starbucks (Nasdaq:SBUX) ritual.

The Bottom Line
The markets are littered with companies that waste money overpaying for share repurchases and corporate acquisitions. Now you can add special dividends to the list. Hypocrites that they are, expect some of these last minute corporate payoffs to result in more than a few of them increasing their debt to make up for the sudden shortfall in capital. Kudos to Glenn Murphy and the Gap (NYSE:GPS) for not succumbing to the herd mentality; its shareholders ought to be thankful its management has a plan and is sticking to it despite the temptation not to.

Corporations might think they're doing the right thing but don't expect President Obama to listen the next time you put your hand out asking for a tax holiday on your foreign earnings. It will fall on deaf ears, as it should. As far as I'm concerned, the only way you solve a debt problem is by earning more or spending less. Ultimately, the Democrats and Republicans will figure this out and when they do, all the tax revenue saved by special and early dividends in the fourth quarter of 2012, will be long forgotten.

At the time of writing, Will Ashworth did not own any shares in any company mentioned in this article.

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

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