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Special Dividends – Are They Really In Your Best Interest?

One of the oddest things to come out of the Fiscal Cliff headlines is the sudden proliferation of so-called “special” dividends.  According to a recent article in the Wall Street Journal and another in CBS News, 349 publicly-traded companies have already moved up the date that they are paying their dividends or are paying additional dividends to shareholders, above what they would normally pay.

What makes these dividends so special?  Technically speaking, the owners of the shares of a publicly-traded company are, collectively, the owners of that company.  You can think of “ordinary” dividends as the money that the company has decided to return to its owners from the profits of its business operations.  Each year, the company’s management and board of directors decides all over again how much of its profits to distribute; it can increase, decrease or maintain its dividend payout, and even pay out more than its earnings.  And, of course, many companies pay no dividends at all; they reinvest their profits in their enterprise or other business activities in hopes of generating more profits and making their company (and stock) more valuable, or they buy back shares of company stock.

These dividends receive special tax treatment under current law; the money is taxed at a maximum 15%–0% for people who fall below the 25% income tax rate.  But that special rate will expire at the end of the year, resulting in a maximum rate of 39.6%, as dividends are taxed as ordinary income, and the ordinary income rates rise.   Of course, the Fiscal Cliff negotiations in Washington could result in an extension of current rates; the truth is that nobody knows, at this point, what is going to happen with next year’s tax rates.

Special dividends are simply a company’s decision to pay its shareholders before rather than after the dividend tax rates are expected to go up.

They fall into two categories.  In one category, you have companies like Johnson Controls (a technology company) and Bon-Ton Stores (fashion apparel) that are paying their normal dividends early.  Instead of paying out their dividend as scheduled in, say, January, they will pay it instead in December as a convenience to shareholders.  Other companies, like Oracle, have gone a step further, and announced that they will bundle several future dividend payments into one bigger pre-December 31 payment.  Oracle will pay 18 cents per share in December to replace the dividends it would have paid out over the next three quarters.

In the other category, you have companies like Costco, Carnival (the cruise line company) and Brown-Forman (a wine and spirits distributor) that are actually borrowing money in order to pay a big dividend before the end of the year, on the theory that they are paying future earnings to shareholders at current tax rates, rather than at higher tax rates down the road.

The implication of some the news reports is that this is a special opportunity, where an astute investor can buy companies that will pay out a hefty dividend.  But in fact, this is almost certainly the wrong strategy.  Companies that are going into debt to make dividend payments are robbing Peter to pay Paul.  To make a special $7 dividend , Costco will borrow $3.5 billion, tripling its long-term debt and has already caused the Fitch rating service to downgrade the company/s bond rating.

In addition, the payment of a dividend results in a simultaneous drop in the stock’s share price.  If you buy a company that makes a dividend payment of 79 cents a share, the share price of that company will drop by 79 cents at the same time.  You come out exactly where you were before, all-in, except you have to pay taxes on that dividend payment.

And some of these special dividends seem to be driven more by the interests of insiders than a convenience to the outside shareholders.  The board of directors of Opt-Sciences, a company that makes special coatings for glass used in cockpits, has announced a special dividend amounting to 65 cents a share, in order, the company said, “to secure for the shareholders the benefits of the soon to be expiring current dividend tax treatment.”  A nice gesture?  It would seem so until you are told that the family of one director, Arthur Kania, controls nearly 66% of the company stock.  He may be more concerned about HIS tax bill than yours.

Another problem with these special dividend strategies is that higher taxes are not inevitable.  And even if Congress takes us over the fiscal cliff, or if part of the next Grand Bargain is to eliminate special treatment of dividends, it won’t be the end of the world–or even the end of tax-efficient ways to reward shareholders.  Companies have often shifted strategies dramatically toward dividends precisely when the new lower tax rate was enacted back at the start of 2003.  Before that, and perhaps in the future, those same companies will redirect the same money they have been paying in dividends into the repurchase of company stock, raising the value of the shares owned by their investors, or reinvesting the money, raising the value of their enterprises and thereby (again) increasing the value of their stock.

Both options would reward shareholders without forcing them to pay immediate taxes on the amount of the reward–a more tax-efficient strategy that some “special” dividend payers might consider before they go into debt to create a tax liability for their shareholders.

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One Response to Special Dividends – Are They Really In Your Best Interest?

  1. Jerry December 13, 2012 at 9:06 am #

    WOW, Rick. Great stuff. Did not know exactly how that worked, the correlation between dividends and stock value, and, of course, taxes.

    Good job, and THANKS…Jerry