Dividends and Capital Gains Planning After the 2003 Tax Act

By Kathy Krawczyk and Lorraine Wright

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Capital Gains

Capital gains arise from the sale of capital assets, such as stocks, bonds, and land, at a price higher than the asset’s cost or basis. If a capital asset has been held longer than one year, the gain is considered a long-term capital gain. If the capital asset has been held for a year or less, the gain is considered a short-term capital gain. Short-term capital gains are taxed at the taxpayer’s regular tax rates. Before the 2003 Tax Act, long-term capital gains were taxed at 20% for taxpayers in the 25% or higher tax bracket (10% for individuals in the 10% and 15% marginal tax brackets).

Special rules applied to the gain on the sale of capital assets held more than five years where the holding period began after December 31, 2000. These gains were taxed at a maximum rate of 18% (8% for individuals in the 10% and 15% marginal tax brackets). Individuals in a tax bracket higher than 15% had the opportunity to make a special “deemed sale election” on their 2001 tax returns, which allowed them to pay the applicable capital gains tax on the asset as though it was sold on January 1, 2001, and then begin the holding period anew on that date. This was to be an irrevocable election.

The 2003 Tax Act’s provisions lowered the rates on long-term capital gains to 15% for taxpayers in the 25% bracket or higher and lowered the 10% rate to 5% for individuals in the 10% and 15% tax brackets, effective May 6, 2003, through December 31, 2008. This provision eliminated the five-year holding period rates of 18% and 8%. In 2008, the new 15% rate remains the same but the 5% rate drops to 0%. In 2009, the capital gain rates will return to the old 20% and 10% rates, and the five-year holding period rules and rates return. The act did not change the capital gain rates for collectibles (28%) and unrecaptured section 1250 gains (25%). The new capital gain tax rates apply to both the regular tax and the alternative minimum tax (AMT) calculations.

Economic effects. Past capital gain tax rate cuts have increased revenue to the federal government in the first two calendar years after the cuts, yet lost revenue thereafter. Some observers speculate that the increase in revenue arises from the unlocking effect of taxpayers who wished to sell their assets and invest in an alternative financial vehicle that might yield a greater return. The responsiveness to lower capital gain tax rates declines as taxpayers’ marginal tax rates decline. In addition, according to Congressional Research Service Report of Congress—Economic and Revenue Effects of Permanent and Temporary Capital Gains Tax Cuts, Updated January 29, 2003 (issued February 26, 2003), the amount of tax revenue decreases as the capital gains are taxed at lower rates. Finally, a capital gains tax cut induces stock sales, which causes downward pressure on stock prices in the market.

One reason Congress gave for reducing the capital gain tax rates was to stimulate consumer spending. The House Ways and Means Committee noted, however, that savings from the capital gains tax cut would be concentrated among higher-income individuals, and as a result the savings were less likely to be spent and would produce only a small economic stimulus.

According to the House Ways and Means Committee Report on Jobs and Growth Reconciliation Tax Act of 2003, HR2 (issued May 16, 2003), “In tax year 2003, the capital-gains tax cut which only covers eight months of the year is worth $30,700 to millionaires, but only $42 to households with incomes between $40,000 and $50,000. Sixty-one percent of the benefits from the capital-gains dividend tax cut go to only 2% of households with incomes over $200,000. IRS data for 2000 show that those with incomes over $500,000 accounted for 57% of all capital gains and dividends, but comprised only 0.5% of taxpayers and accounted for only 17% of income from all sources.”

In contrast, according to the aforementioned Congressional Research Report, the capital gains tax accounts for less than 1% of income taxes for the bottom 70% of taxpayers.

Because the 2003 act’s capital gain rate reductions are temporary, they may raise revenue initially but lose a larger amount of revenue in the long run. By appropriately timing the sale of capital gain assets, a taxpayer is able to choose among different tax rates and rates of return. According to a 2003 report by the Congressional Research Service, a similar event occurred as a result of the 1986 Tax Act. When capital gain tax rates rose from 20% to 28%, there was a rise in capital gains taxes collected, from 4.22% of GDP in 1985 to 7.6% in 1986 (before the rate increase was effective); it then fell to 3.2% of GDP in 1987.

Effects on individual taxpayers. The lower capital gain tax rates enacted by the 2003 Tax Act effectively eliminated the five-year holding period election until 2009. Taxpayers that previously made this election and recognized some capital gain on their 2001 tax returns might consider filing an amended 2001 return if Congress permits revocation of the deemed sale election in subsequent legislation.

An additional problem arises for a taxpayer who sells assets that are being held long term in order to take advantage of the five-year holding period rules. If these assets are sold in order to take advantage of the current lower rates, the replacement assets must be held another five years in order to take advantage of the special five-year rates in the future. The taxpayer must also be sure the like-kind exchange rules do not apply to the transactions.

Planning opportunities and consequences. Taxpayers can currently give up to $11,000 in assets per year to family members without incurring a gift tax. The new capital gain tax rates thus present a good tax planning opportunity. Taxpayers can gift appreciated capital assets to children over age 13 (to avoid “kiddie tax” rules). The children could then sell the assets now and pay a 5% capital gain tax rate, or wait until 2008 and pay a 0% capital gain tax rate (assuming their other income is low enough). The children can then use the money to fund college expenses or start a business, or give it back to their parents or grandparents.

One negative side effect of the reduction in the capital gain tax rates may be a reduction in charitable contributions of appreciated capital assets. Taxpayers may be tempted to sell appreciated capital assets themselves rather than contributing those same assets to charity.

Dividends

Before the 2003 Tax Act, dividend income was taxed to individuals as ordinary income at their regular marginal tax rates. The act changed the tax rates applicable to dividends in an indirect manner. First, it increased net capital gains by qualified dividend income for purposes of applying the maximum capital gains rate. At the same time, the act reduced the maximum capital gain tax rates for individuals, as previously discussed. As a result, it effectively lowered the tax on individuals receiving qualified dividends to 15% (5% if they are in the 10% or 15% regular tax bracket). It does not change the character of dividend income: Dividends are still considered ordinary income and cannot be offset against net capital losses.

Under the 2003 Tax Act, qualified dividend income is defined as dividends received during the year from domestic corporations (both publicly traded and private) and qualified foreign corporations. Dividends that are excluded from the definition of qualified dividend income include the following:

• Dividends from tax-exempt organizations;
• Dividends from certain mutual savings banks;
• Dividends deductible under section 404(k) paid on employer securities;
• Dividends received to the extent the taxpayer is under an obligation to make related payments for similar positions;
• Dividends from real estate investment trusts (REIT) or regulated investment companies (RIC), unless they come from qualifying dividends that the REIT/RIC received; and
• Dividends on stock not held more that 60 days out of the 120-day period beginning 60 days before the stock’s ex-dividend date (90 and 180 days if preferred stock).

As noted, dividends from REITs are excluded from qualified dividend income and are ineligible for the 15% rate. REITs by definition must pay out at least 90% of their taxable income to shareholders, and receive a dividend paid deduction for this amount. This combined effect allows a REIT to bypass the corporate tax. The 15% rate will, however, apply to capital gains on the sale of REIT stock, REIT capital gain distributions, REIT dividends attributable to dividends received by REITs from non-REIT corporations, and REIT dividends to the extent they are attributable to income subject to tax by the REIT at the corporate level (built-in gains).

A qualified foreign corporation is defined as a foreign corporation incorporated in a U.S. possession or eligible for benefits of a treaty with the United States that includes an exchange of information program. It also includes nonqualified foreign corporations if their stock with respect to which the dividend is paid is readily traded on a U.S. securities market. The 2003 Tax Act specifically excludes from the definition of qualified foreign corporations any foreign personal holding company, foreign investment company, or passive foreign investment company.

Like the capital gain rate changes, the reduced dividend tax rates are effective for taxable years beginning after December 31, 2002, through 2008, after which the tax rates in effect before the 2003 Tax Act return. During 2008, the 5% tax rate for dividends and capital gains received by low-income bracket taxpayers is eliminated. There is one important difference in timing between the new capital gain tax rates and the new dividend tax rates: The new 15% rate applies to dividends received after December 31, 2002, but does not apply to long-term capital gains until May 6, 2003.

To accommodate the reporting requirements associated with dividends, the IRS has modified Form 1099-DIV to separately report qualifying dividends and net capital gains (both pre– and post–May 6, 2003). Form 1040 Schedule D has also been revised to add dividends to capital gains for purposes of the special tax calculation for lower capital gain tax rates. No guidance from the IRS currently exists related to estimating qualified dividends for purposes of estimated tax payments.

Interaction with Other Taxes

The 2003 Tax Act changes in tax rates on capital gains and dividends affect other areas of the tax law as well. It specifically lowers the accumulated earnings tax and personal holding company tax rates to 15% percent, and provides that the lower capital gain and dividend rates apply to the AMT calculation in addition to the regular tax calculation. In addition, the dividend rate differential affects the calculation of the foreign tax credit limitation when an investor receives dividends from a foreign corporation.

To eliminate a double benefit, dividends that qualify for the lower tax rates are not included in investment income for determining the investment income limitation for interest expense. In addition, extraordinary dividends will create a long-term capital loss upon the sale to the extent of the extraordinary dividend. Finally, amounts treated as ordinary income from the disposition of section 306 stock will qualify for the reduced dividend tax rates.

Effect of the dividend rate changes on the economy. According to the Federal Reserve Board’s survey of consumer finances, 17% of U.S. families received dividends in 2000. The receipt of dividends is related to income. According to Leonard E. Burman and David L. Gunter (“17 Percent of Families Have Stock Dividends,” Tax Notes, May 26, 2003), less that 4% of families with income under $200,000 received dividend income, while 58% of those with income greater than $200,000 received dividends.

The Congressional Budget Office’s “Cost Estimate for H.R. 2” estimated the reduction in revenue due to reductions in taxes on dividends and capital gains (combined) as $149 billion over the eight-year period it forecast. Specifically, the decrease in government revenues for each year 2003 through 2010 was predicted as follows (amounts in millions):

2003 -- $ 4,312      2007 -- $25,717
2004 -- $18,434     2008 -- $26,747
2005 -- $20,550     2009 -- $19,180
2006 -- $23,123     2010 -- $10,025

Planning for the effect of the dividend rate changes on individual taxpayers. The reduced tax rates for capital gains and dividends increase the attractiveness of corporate stock as compared to debt instruments. As a result, corporate and Treasury bonds, and other fixed income securities like certificates of deposit and money markets, have become less appealing to individual taxpayers, although U.S. corporations still get tax benefits from issuing debt financing, in the form of deductions for interest expense, that they do not get from issuing stock. The trade-off between the dividend tax rate benefits to individual shareholders and the interest expense tax benefits to corporations will differ between corporations and may not increase the availability of qualified stock investments.

Some speculate that U.S. markets may instead see an increase in preferred stock or other hybrid securities that are treated as stock for tax purposes but have some of the nontax benefits of debt. Investors must ensure that an investment in preferred stock generates dividends qualifying for the reduced rate. A BusinessWeek.com special report (“What the Cuts Mean to You,” by Mike McNamee, with Susan Scherreik) notes that “two-thirds of the $208 billion market in preferred shares won’t qualify for the tax break on dividends, because their payout is more akin to interest than to corporate dividends,” and predicts that investment in preferred-stock mutual funds may increase to ensure that the dividends qualify for the reduced tax rate.

Corporate and Treasury bonds, and other fixed income securities like CDs and money-market accounts, may make better investments for pension plans, IRAs, and other tax-deferred accounts. Taxpayers will not have to pay taxes on income from these investments until they receive distributions from the accounts. Although these investments do not qualify for the reduced dividend and capital gain tax rates, there are many nontax reasons for using a retirement account. The appeal of other tax-deferred investments, such as variable annuities, may be diminishing, however. Investors may find it cheaper to pay taxes each year on dividends and capital gains at the low 15% rate (especially if they are in the top brackets) rather than defer income but pay ordinary tax rates when the income is received.

The 2003 Tax Act provisions equating the tax rate for both dividends and capital gains may also reduce the importance of tax planning related to structuring transactions to ensure that any gain recognized by individual shareholders is classified as capital gains rather than as dividends. Consider stock redemptions as an example. If a corporation redeems its stock, the redemption proceeds are treated as dividend income to the individual taxpayers unless the redemption can be treated as an exchange and accorded capital gain treatment under IRC section 302. Prior to the 2003 Tax Act, individuals preferred exchange treatment as opposed to dividend treatment, because capital gains were subject to the beneficial lower capital gains tax rates while dividends were subject to ordinary income tax rates. Now, both types of income are subject to the same tax rates.

The reduction in the dividend tax rate also narrows the tax difference businesses have to consider when debating between operating as a C corporation or as a pass-through entity such as a partnership. Although operating as a C corporation will still mean a higher tax cost due to double taxation of income, that gap has narrowed. Other nontax factors may become more influential in the decision of which entity to use.

Most tax law revisions benefit industry sectors differently. The reduced dividend tax rate would seem to benefit established companies, such as manufacturers and banks, which have a history of paying dividends. Conversely, the technology sector would not benefit, because such companies typically reinvest earnings into additional research and development rather than paying dividends. Microsoft’s recently announced dividend policy, however, may mark the start of a different trend.

One last planning consideration would be the frequent practice of borrowing funds to purchase dividend-paying stocks. Assuming the interest is deductible as investment interest, this will generate a tax savings at regular tax rates, while the resulting dividend income is taxed at the preferential 15% rate. This can create positive after-tax cash flows for individual investors. The big limitation to this approach is the investment interest limit. Dividends cannot be considered investment income and also be subject to the 15% tax rate, so investors need other sources of investment income in order to fully deduct the investment interest expense.