The President’s Jobs and Growth Plan: The Dividend Exclusion is Not Complex

The President’s Jobs and Growth Plan: The Dividend Exclusion is Not Complex

President Bush’s tax plan is based on a fair and simple idea: Tax corporate income once – and only once. This proposal makes the tax code fairer to investors, and it does so in a manner that is easy on both corporations and investors.

For most shareholders, the only change they will see is a reduction in their taxable income.

For corporations, determining benefits to shareholders generally requires just two new calculations, while any new reporting requirements should be similar to reports they already issue.

Taxpayers will have less incentive to shield income from tax by engaging in complex financial and tax planning schemes. For this reason, the proposal will lead to less complexity and lower compliance costs.

What Investors See – Increased Dividends

The vast majority of investors are unlikely to see any increase in record-keeping.

Taxpayer dividends will be reported in the same manner that dividends are reported now, on IRS 1099 forms mailed at the beginning of each year.

For most shareholders, adjustments to their cost basis will also be made as they are made now – through their mutual funds or brokerage accounts.

The only difference is shareholders should see a substantial decline in their taxable dividends and an increase in their return on investment.

Most stock-owning households own their stock through mutual fund companies or brokered accounts. These companies already track basis adjustments on behalf of shareholders. Under the President’s plan, they would continue to make these adjustments.

In 2002, about 36 million households owned stock outside employer-sponsored retirement plans. About 21 million households held stock directly, primarily through brokerage accounts, and 28.7 million households held stock indirectly through mutual funds.

Direct ownership outside brokerage accounts is generally done by sophisticated taxpayers who receive significant advice and assistance in managing their portfolios. For those taxpayers, whatever compliance costs they incur will be wholly voluntary.

The Corporate Calculation – Tax-Free Dividends

To calculate the amount of dividends that can be distributed tax-free to shareholders, a corporation will need to annually compute the amount – the Excludable Dividend Amount (EDA) – that reflects income that has already been taxed.

Calculating this amount requires just one piece of information – a company’s tax liability from the return filed in the prior year.

A corporation with $100 of income that pays $35 of U.S. income taxes will have an EDA of $65 that can be distributed as tax-free dividends.

A corporation would report these excludable dividends to shareholders on the 1099 form, just as they report taxable dividends.

The Corporate Calculation – Retained Earnings

Shareholders of corporations that retain their taxable earnings would see a benefit as well.

The cost of their shares would be adjusted upwards to reflect the value of the retained stock.

For the corporation, this adjustment – called a Retained Earnings Basis Adjustment – requires just two pieces of information – the corporation’s EDA less any excludable dividends distributed to shareholders.

Corporations already report basis adjustments to their shareholders. Under current practice, when a corporation sells a subsidiary, the cost basis for shares of the new independent corporation must be established, while the basis for shares in the parent corporation must be adjusted downward.

For shareholders, REBA-related adjustments are excluded from taxes. When a shareholder sells his or her stock, whatever capital gain they incur is reduced by the total REBA-related adjustments.

REBA adjustments will be reported on 1099 forms alongside excludable dividend amounts.

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