Corporate America Seeks to Elude the Taxman Through Special Dividends

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STEPHEN WILKES / Gallery Stock

Checkout counters at a Walmart in New Brunswick, N.J.

While the President and Congress have seemingly made little progress in reaching a compromise that would help the country avoid the fiscal cliff, corporate America isn’t sitting idly by. Parts of the fiscal cliff are tax increases to investment income like capital gains and dividend payments, and many firms are either speeding up regularly scheduled dividends or issuing unplanned dividends in order to help their shareholders avoid higher tax rates in the future.

The Bush tax cuts in 2003 lowered the top income-tax rate on qualified dividends by 15%. With the expiration of those tax rates and with the introduction of taxes associated with President Obama’s health care law, the top tax rate on dividends is set to rise to as high as 43% for high-income earners. In reaction to this possibility, firms like Costco, Dillards and, most recently, Dish Network have announced one-time payments to their shareholders in order to funnel profits to investors at a much lower tax rate, while companies like Walmart, Oracle and Walt Disney have pushed up the date of previously scheduled dividends. According to the financial-data firm Markit, U.S. firms are on pace to issue 134 special dividends in the fourth quarter of 2012, up from an average of 31 in previous years.

Perhaps unsurprisingly, of the firms that have issued special dividends so far this year, a disproportionate number of them have a heavy concentration of insider ownership. According to Chaitanya Gohil, vice president of Markit Dividend Research:

Many investors think that even if a grand bargain is struck in Washington, there is a good probability for dividends and capital tax rates to rise.  So, in cases where insider holdings are concentrated in the board and executive levels, there exists not only the incentive but also the capability to declare special dividends.

Critics of corporate America have for several years been disparaging large firms for sitting on hoards of cash. The record amounts of cash on corporate balance sheets, they say, could be better deployed by hiring workers or, at the very least, by funneling the money back to shareholders through dividends. As Matthew Yglesias of Slate wrote last week:

For a while now people have been wondering what, if anything, would get corporate cash “off the sidelines” and into the investment arena. But the special dividends path is an alternate way of doing it. Rather than investing the idle money, firms can disgorge it to their owners who’ll transform it into luxury durable goods (fancy cars) and residential investment (fancy houses) with the rising demand for those items — rather than corporate investment — being the demand driver.

So are these payments a sign that large firms are finally heeding this advice? Not necessarily. As Morningstar analyst Josh Peters wrote in a recent market commentary, special dividends aren’t a great service to investors or particularly bold moves for corporate managers to take, because they are one-off events. He argues that since these are one-time payouts, investors shouldn’t chase special dividends:

Long-term investors in companies that haven’t been paying acceptable regular dividends might end up slightly better off than before, and a few short-term traders could wind up with bigger tax bills, but the burst of activity seems unlikely to leave a lasting mark on the market except for this: These irregular dividends are yet another reminder of just how stingy most American corporations are when it comes to paying regular dividends.

And while it’s certainly better for corporations to return unused cash to its owners rather than have it sit idly in bank accounts, what the U.S. economy needs more than anything else is for its large firms to begin investing again through worker-hiring and other investments. Peters closes his commentary on these special dividends by quoting something Warren Buffett wrote to his clients back in 1965: “It is going to continue to be the policy of [Buffett Partnership Ltd.] to try to maximize investment gains, not minimize taxes. We will do our level best to create the maximum revenue for the Treasury — at the lowest rates the rules will allow.”

In other words, Warren Buffett thought the best way to make money was to find companies that were willing to take chances and invest in opportunities for extraordinary growth. But corporate America isn’t in a daring mood right now. According to a recent study completed by the Wall Street Journal, half of America’s largest publicly traded companies have recently announced plans to rein in capital expenditures next year. Whether you blame the federal government for creating an environment of uncertainty or you blame corporations for being far too risk averse, the bottom line is that business is not displaying the sort of audacity needed to help create a robust economic recovery. And these recent special dividends are just more evidence supporting this fact.