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There have already been over 80 Special Dividends announced this year.
August saw $34 billion making a new monthly record. Special dividends
are paid once and are above and beyond any quarterly dividend payments.
Many times they are quite large in proportion to the stock price. As an
example: AOL, trading at $34, has declared a $5.15 dividend with a
record date of December 5, 2012.
The tax treatment to investors of special dividends is more complex
than the taxation of smaller dividends that are paid out of earnings
more regularly. All dividends would need to be held for more than 61
(unhedged) days in order to qualify for the current 15% tax rate.
However, if the dividend is more than 10% of the value of the
stock at the time of the distribution, it is considered an
“Extraordinary Dividend” governed by IRC Section 1059. Section 1059 is
designed to discourage “dividend stripping” by taxable investors.
Although, for those with exclusively short-term gains, there still
exists a trading opportunity.
A second and more elusive question is whether the dividend is actually
a dividend for tax purposes. Only dividends paid out of a corporation’s
E&P (“earnings and profits”) are actually taxed as dividends.
Payments labeled dividends that are not paid from E&P are a
“return-of-capital”. Any amount received as a R.O.C. dividend is to be
taken as an adjustment in your cost basis of the shares; no taxable
dividend income is created when receiving a R.O.C. dividend. It is
unusual for regular quarterly dividends to be R.O.C. dividends. Since
special dividends are quite large it is not unusual for some of the
special dividend to be taxed as a R.O.C. instead of being taxed as a
dividend.
Ironically, although the analysis of whether the dividend is a dividend
or a R.O.C. is so critical, many times the answer is not known at the
time of receiving the dividend. The corporation must conduct an
E&P study covering both historic cumulative E&P and current
fiscal year E&P; either can create taxable dividends. The AOL
documents and IR department have not provided any guidance (this is not
always the case). Because of AOL’s taxable earnings history, and its
current outlook, it is a question as to the tax status of this dividend
covering so many taxable holders.
How an investor is to be taxed on a special dividend must be analyzed
before the record date so that the client can act if indeed this “great
news” can whipsaw them tax wise. Let us first assume the dividend is
paid completely out of E&P and thus a dividend as we know it. The
taxable investor thinking this is a quick trading opportunity can
easily find themselves in the worst of all possible outcomes, fully
taxable income balanced by losses that might not be deductible. John
the trader buys AOL at $34.15, holds the stock past the record date
when the shares go ex-dividend by the $5.15 dividend. John sells one
week later selling at $30, reaping a total of $35.15 counting the
dividend, thus making $1. Next April John’s CPA informs him that the
trade threw off $5.15 of non-qualifying dividend income taxed at 35%
and $4.15 in capital loss that John could not currently utilize against
any realized gains. That $1 pretax profit turned into a current tax
bill of $1.80 and a capital loss carry forward. An offshore hedge fund
would be even more disadvantaged by trading over the record date due to
withholding issues.
The luckiest taxable investor would be one who holds AOL over the
record date, satisfies the requisite unhedged 61 day holding period and
has only short term gains at tax time. This investor could receive
$5.15 in tax-favored 15% taxed dividend income while generating capital
losses deductible against 35% gains. This kind of opportunity was the
target of IRC Section 1059 that governs “extraordinary dividends”.
Section 1059 allows the large dividend to receive the lower tax rate
but makes all losses from trading long term not short term. This is to
stop the generation of short term loss and corresponding dividend
income. Ironically if a taxpayer has no long term gains (exclusively
short term gains), long term losses from an extraordinary dividend wind
up offsetting short term gains dollar for dollar.
Each of the last few years have threatened the possible expiration of
the Bush tax cuts and thus have spurred companies with large cash
hoards to get that money out to the owners, the shareholders, before
the tax increase kicked in. This is what a taxpayer owning a private
company would do. Not surprisingly many of this year’s special
dividends have come from companies with lots of cash and high insider
ownership. Anixter, Domino’s Pizza, American Eagle, DSW and Loral Space
all fit the bill. I’ve seen reports predicting future big payments from
the Limited, Buckle or Wynn. Historically more than 50% of all special
dividends have been declared in November and December and we see no
reason to think this year will be any different.
Investors should carefully consider the risks involved in purchasing any of the securities mentioned in this article.
*Additional Reading: Barrons - Bonus Babies
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