Explanation of The Dividend Exclusion in The Bush Tax Plan

provided by CCH

President Bush announced an economic stimulus package on January 7 containing more than $670 billion in individual and business tax cuts over the next 10 years. The centerpiece of the package, and the proposal causing the most controversy, is the proposed exclusion from income of dividends paid by a corporation to shareholders. The Treasury Department on January 14 published a fact sheet explaining the proposed exclusion and highlighting how it would stimulate economic growth.

Current Law

Generally, corporate earnings may be subject to two levels of tax: one at the corporate level and one at the shareholder level. Income earned by a corporation is taxed at the corporate level. If the corporation distributes earnings to shareholders in the form of a dividend, the income is generally taxed again at the shareholder level, depending on the shareholder's income.

If a corporation retains earnings, the value of corporate stock generally increases to reflect the retained earnings. When shareholders sell their stock, that additional value is taxed in the form of capital gains, generally at a rate of 20 percent. The resulting rate of tax on corporate income can reach as high as 20 percent.

Disadvantages of Current System

According to the Bush administration, the current treatment of dividends affects business and investment decisions in ways that can be harmful. The current system:

  • creates a bias in favor of debt, as compared to equity, since payment of interest is deductible, whereas return on equity is not;
  • creates a bias in favor of unincorporated entitles that are not subject to double taxation;
  • encourages retained earnings, rather than distribution;
  • encourages the use of share repurchases since earnings would be distributed at reduced capital gains tax rates; and
  • encourages activities that minimize tax liability.

Advantages of the President's Plan

The Treasury Department highlighted some of the key points of the Bush plan, including:

  • Many of the 35 million American households that currently receive taxable dividends will benefit;
  • About one-half of taxable dividends to go senior citizens, many of whom depend on that income;
  • Corporations will now have good reason to pay them;
  • Dividends generally indicate that a corporation is doing well and the current system disfavors dividend payments. Under the proposal, taxes would not affect the decision to pay dividends; and
  • Many of the country's trading partners also give some relief from the double tax on corporate earnings, so the U.S. is currently at a disadvantage.

Corporations Not Fully Taxed

Under the Bush plan, less cash would be paid tax-free to a shareholder. This is because not all the profits have been fully taxed to the corporation.

Example

Assume $10 of profits per share, $3.50 in taxes per share, and $6.50 in after-tax income per share. Suppose the corporation paid out $4 in tax-free cash dividends per share and reinvested the remaining $2.50 per share. The proposal would allow shareholders to add the amount the corporation retained to the amount they paid for their stock. This treats shareholders the same as if they received a cash dividend and reinvested the dividend in new shares of the company. The $2.50 of retained earnings would be tax-free, just as if it had been paid as a cash dividend.

Special Entities

Under current law, the income of S corporations generally is not subject to corporate tax. Therefore, the current rules would not change under the Bush plan. Under the proposal, a mutual fund or a real estate investment trust that receives excludable dividends may pass those dividends through tax-free to shareholders.

End-of-Year Shareholder Information

The corporation, mutual fund or broker would provide shareholders the information they need on the end-of-year tax statement sent every January. The statement would inform shareholders of (1) the amount of tax-free dividend; (2) how much of the dividend is taxable, if applicable; and (3) the amount a shareholder can add to what they paid for the stock to determine their tax upon sale.

By Lisa R. Neuder, CCH News Staff

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