Eaton Vance on Washington

April 2012

How might a significant increase in the dividend tax rate at year-end affect the values of dividend-paying stocks?
In his budget released last February, President Obama changed his position and proposed allowing the dividend tax rate for families with income above $250,000 to rise in 2013 to the ordinary income tax rate, rather than to remain at the lower capital gains tax rate. The President’s view notwithstanding, most members of Congress appear to prefer keeping the dividend tax rate commensurate with the capital gains rate (although the Democrats would raise both rates in tandem to the low- to mid-20s). Thus, if the parties are able to reach an overall compromise on 2013 tax rates during the year-end lame-duck session, they might well keep the dividend tax rate below the ordinary income rate. Absent legislation, however, the Bush tax cuts will expire and the maximum dividend tax rate will increase in 2013 to almost 44%, the same as the ordinary income tax rate.

If it happens, a tripling of the dividend tax rate could affect the value of dividend-paying stocks. Presumably, the value of stock purchased solely for dividends, such as public utilities, would decrease so that after-tax percentage returns would remain constant. Stocks purchased partially for dividends and partially for appreciation potential (such as consumer products) could also be affected, although presumably not by as much.

More interesting is whether a tripling of the dividend tax rate could cause companies to change their dividend-paying policies. Companies might decide to keep dividends at their current levels rather than increasing them in future years. They then would use retained cash to repurchase stock, permitting investors to realize earnings as lower-taxed capital gains. If that happens, dividend-paying stocks could be less desirable as a source of increasing income.

If the Supreme Court rules that the health care reform law is unconstitutional, will the new 3.8% tax on investment income, nonetheless, take effect next year?
Last month, the Supreme Court heard oral arguments on the constitutionality of the health care reform law’s “individual mandate,” which requires Americans to have health insurance or pay a penalty. The Court is expected to render its verdict in June.

The health care reform law is financed in part by a new tax on investment income scheduled to take effect in 2013. Beginning next year, families whose overall income is above $250,000 (individuals with income over $200,000) will pay an additional tax of 3.8% on taxable investment income such as interest, dividends, capital gains, rents and royalties.

If the Court strikes down the entire health care reform law, then the 3.8% surtax, which is part of that law, presumably would not take effect. If, however, the Court invalidates only a portion of the law¬–such as just the individual mandate–then the 3.8% tax will go into effect next year. In that case, Congress at some point presumably will have to revisit the law to determine whether the health care reform regime still works. But Congress is unlikely to do so in an election year–and, given the contentious nature of health care reform, may not agree on changes for quite awhile afterward.

Of course, it is impossible to predict the outcome with certainty without reviewing the final opinion from the Court.

Assuming it goes into effect, will the 3.8% tax apply to all investment income received by families with total income over $250,000?
The 3.8% tax applies only to taxable investment income. Thus, the tax does not apply to non-taxable income such as tax-exempt municipal bond interest or life insurance death proceeds. Also, the tax does not apply to any amounts withdrawn from qualified pension plans and IRAs.

Also, the 3.8% tax applies to taxable investment income only to the extent that income, plus all other adjusted gross income, exceeds $250,000 for a family ($200,000 for an individual). For instance, suppose a family has $200,000 of wage income and $80,000 of dividend income. Total adjusted gross income of $280,000 exceeds $250,000 by $30,000. Thus the 3.8% tax would apply to $30,000 of the dividend income.

February 2012

Is there a chance the parties will agree to keep the dividend tax rate the same as the capital gains tax rate in 2013, rather than allowing it to increase to the ordinary income tax rate?
Prior to the Bush tax cuts, dividends were taxed as ordinary income. The Bush cuts dropped the dividend tax rate to the capital gains tax rate (currently 15%).

Until recently, both parties seemed to agree that the dividend tax rate should remain commensurate with the capital gains rate (the Democrats would raise both rates to 20% for high-income taxpayers). The Democrats’ view may change, however, in the wake of the debate over Governor Romney’s tax returns. Romney’s overall tax rate was low because much of his investment income was taxed at the 15% rate. Letting the dividend rate return to the ordinary income rate would seem more consistent with the President’s desire to assure that wealthy individuals pay tax at the same rate as the middle class (the so-called “Buffett rule”).

Even if both parties agree in principle to a lower dividend tax rate, that can be accomplished only if Congress and the Administration adopt compromise legislation to extend some or all of the Bush tax cuts. Such an agreement likely will have to be hammered out late this year during a “lame duck session” of Congress after the election. Absent legislation, the Bush tax cuts will expire in their entirety and the dividend tax rate will return to the ordinary income tax rate in 2013.

What do you see for the estate tax exemption in 2013?
The current gift and estate tax exemption is $5 million per individual. If Congress does not extend that provision, in 2013 the exemption will return to $1 million.

In his budget last year, the President proposed a $3.5 million exemption beginning in 2013. Again, however, his rhetoric regarding raising taxes on the wealthy may cause him to change that view. We should know in the next month, when the Administration releases its 2012 budget proposal, whether the President continues to support a $3.5 million exemption or now prefers a return to $1 million.

If the parties adopt compromise legislation addressing the Bush tax cuts later this year, they likely will also compromise on estate taxes, probably setting the 2013 exemption somewhere between $3.5 million and $5 million. But if they fail to compromise, look for a $1 million exemption in 2013. Given this uncertainty, gifting in 2012 may make sense.

You have painted a bleak picture about Congress's inability to keep tax rates low during the lame duck session likely to occur at the end of this year. Is there a prospect of more favorable legislation in 2013?
There is some prospect that, with the heat of the election off next year, the new Congress and the Administration could try to tackle tax reform - eliminating loopholes, simplifying the tax code, and reducing the top tax rates. If the parties can agree on a tax reform proposal, they might even agree to entitlement reform (the so-called “grand compromise”) and solve the deficit problem as well.

As we say in Washington, though, tax simplification is complicated stuff. The last time tax reform was undertaken successfully was in 1986, when Ronald Reagan and Tip O’Neill managed to negotiate a bipartisan plan. Whether any of this can be accomplished in today’s partisan atmosphere is far from certain. The process likely will get started in 2013, but it could well collapse into another imbroglio of partisan bickering and finger pointing.