In a bold move to change our corporate tax system, President Bush has proposed an income tax exemption for corporate dividends. The exemption would create a whole new world of corporate taxation for C corporations. As evidenced by many fundamental changes over the years, our corporate tax system is not engraved in stone. Historic changes could be heading our way once again.
With this change in the air, corporations must understand-possibly on short notice-how a new tax policy change will affect corporate decisions and shareholder relationships. Many of our clients have asked whether this historic change will be enacted and how it will work. With respect to the status of this change, the President's team is working hard. The President clearly intends to have the dividend exemption survive the legislative process.
The current legislative battle has been joined by many prominent industry groups. From the banking industry, the American Bankers Association, the Independent Community Bankers of America, and America's Community Bankers "enthusiastically support" the President's dividend exclusion proposal. Many industry groups believe that now is the time to integrate corporate and shareholder taxes.
As support for change, the administration is quick to point out the dangerous bias of the current system, namely the preference for corporate debt, the encouragement for retaining rather than paying dividends, and the incentive to engage in transactions solely to reduce taxes. The administration has a point.
In the mid-1960s, 75% of large companies paid dividends. By the mid-1990s less than 25% of these companies paid dividends. The sheer number of companies paying dividends has fallen dramatically. The amount paid as a dividend has also fallen. In 1992, 23% of pretax earnings were paid out in dividends. By 1999, only 14% of pretax earnings were paid as dividends. Given the high tax cost, corporations are choosing not to pay dividends.
Instead of paying out dividends, cash-laden companies pursue other paths. One popular path is share repurchases or share "buy-backs." In 1999, more than 34% of large publicly traded companies engaged in share repurchases, up from 28% in 1992. More revealing is that by 1999, almost 20% of earnings were paid out by share repurchases, nearly triple those of 1992.
The Current Dividend System
But why are corporations choosing not to pay dividends? A review of the current dividend system illustrates why. Under the current system, a corporation pays a tax on its taxable income, generally at the rate of 35%. Then, when the corporation distributes after-tax earnings as dividends, each shareholder includes the amount of the dividend in gross income and pays tax at the shareholder's individual tax rate. In effect, the corporate earnings are taxed twice-once by corporation and then a second time when received by the shareholders.
The President's Dividend Exemption Proposal
Under the President's proposal, a change would be introduced to the tax treatment of shareholders receiving dividends. Shareholders could exclude the excludable dividend amount or "EDA." The EDA, as discussed below, measures the corporation's fully taxed income, and the payment of corporate taxes drives the amount of EDA. In addition to the income exclusion, shareholders could increase the basis in their corporate stock to the extent the EDA exceeds the dividends paid by the corporation during the calendar year. A basis increase could then be used to reduce gain when the stock is sold.
Excludable Dividend Amount
New tax computations lie at the heart of the new dividend exclusion system. The new provision is not simple. The "excludable dividend amount" is the important calculation. The EDA generally will be a fraction, the numerator of which is the amount of federal income tax in excess of all nonrefundable credits shown on a corporation's income tax return filed during the preceding calendar year (applicable income tax) and the denominator of which is the highest corporate tax rate (35% under present law). The EDA is decreased by the amount of federal income tax taken into account in computing the increase in the EDA.
To the extent that the EDA for a calendar year exceeds the maximum amount of dividends that can be paid by the corporation in the calendar year (determined by reference to the corporation's earnings and profits), the excess is added to the EDA for the succeeding year.
Retained Earnings Basis Adjustments
The new dividend exclusion system also has a basis adjustment feature. Under this feature, if the amount of the EDA for a calendar year exceeds the amount of dividends paid by a corporation during that year, a shareholder is allowed to increase the shareholder's basis in the corporation's stock by the portion (if any) of the excess allocated by the corporation to the stock.
A corporation will advocate these basis increases in the same manner as if the corporation actually had made dividend distributions, except that the corporation cannot allocate any basis increase to most kinds of preferred stock. The allocated basis is added to the shares of stock the taxpayer holds and does not affect the holding periods of the shares.
Looking Ahead
This year has already become a very historic year for our country. The Bush administration has undertaken bold initiatives on many fronts. The events in the Middle East could reshape the future. New tax reform could also reshape corporate tax and dividend payment policies.
During this historic year, Rothgerber Johnson & Lyons LLP is proud to celebrate our centennial anniversary of delivering the finest in legal services to our clients. Over our 100-year history, we have helped many clients navigate through historic fundamental legislative changes and new regulatory environments. If you or your organization should need our services in understanding a new corporate tax law landscape, please give us a call.