Understanding Bush's tax proposal
By Jeannine Aversa
Associated Press
WASHINGTON — Having trouble figuring out whether you would benefit from President Bush's proposal to eliminate taxes that individual investors now pay on dividends? Experts who make their living by deciphering the tax system are scratching their heads, too, and say there are no simple, one-size-fits all answers.
The idea of freeing dividends from taxes at the shareholder level is not as clear-cut as it sounds, tax experts say.
Questions and answers about the issue, and a look at how you might fare if the plan were passed by Congress and signed into law:
Q: What is a dividend?
A: A payment that a corporation makes out of its earnings to people who own its stock.
Q: How are shareholders now taxed on dividends?
A: Dividends are taxed at the standard, individual income-tax rates, which range from 10 percent to 38.6 percent.
Q: Will all of my dividends be tax free if Bush's plan takes effect?
A: No. In general, you would get a tax break if the corporation paying you the dividend paid federal corporate taxes on the earnings. Generally speaking, you would not get the tax break if the corporation did not pay corporate taxes on the earnings.
The Treasury Department says that roughly 35 million households now receive dividends that are taxed, and most will benefit from Bush's proposal.
Q: Why would my tax break depend on whether the corporation paid taxes on the earnings?
A: The plan is aimed at getting rid of what the administration calls a double tax on corporate profits. When a corporation earns a profit, it can pay taxes at rates as high as 35 percent. Also, when a corporation pays dividends to shareholders out of its remaining after-tax income, shareholders must pay taxes on those dividends based on their standard, individual income tax rates.
Q: How am I supposed to figure out if I get a tax break on my dividend?
A: You won't. Corporations would have to calculate how much of their income has been fully taxed. They need to do that to determine how much they can pay out in tax-free dividends to shareholders. It is up to the corporation to decide how much, if any, of the tax-free profit it wants to distribute as a cash dividend.
Q: How would I know?
A: Corporations, mutual funds or stockbrokers would tell shareholders in end-of-year tax statements, such as a 1099 form, mailed out to homes every January. The statement would let you know how much of your dividend is tax free and how much of the dividend, if any, is taxable.
Q: Are people out of luck if they hold shares in a company that does not pay a dividend?
A: No. They would get a tax benefit too, but only when they sell their shares. A corporation that paid taxes might decide to retain profits — perhaps investing the money in plant and equipment — instead of paying dividends to shareholders.
In that case, a shareholder — on paper — would get a "deemed dividend," the amount the corporation could have paid as a tax-free dividend. Shareholders would get to take advantage of this kind of dividend only when stock is sold. This dividend would be added to the shareholder's "basis" — meaning what you paid for the stock — thereby reducing the amount of money that you would have to pay a capital gains tax on.
Say you bought one share of stock for $90 and sold it for $100 and got a deemed dividend of $2.50 per share. Instead of paying taxes on a capital gain of $10, you would pay taxes on a gain of $7.50 — $100 minus $92.50.
Q: How would I get this deemed dividend information?
A: Corporations would provide you with this information on end-year-tax statements, such as the 1099.
Q: Is it possible for a corporation to pay me a tax-free dividend and provide a deemed dividend, too?
A: Yes.
Say a corporation is allowed under the Bush plan to pay out $100 in tax-free dividends per year. But the corporation decides it wants to pay only $60 in cash dividends a year and plow the remaining $40 back into the company. That $40 would be the deemed dividend.
Q: Do I get a tax-break on my mutual fund investments?
A: It depends. You would get a tax break to the extent that the mutual fund is invested in stocks of companies that pay taxes and pays a dividend to shareholders. But you would have to pay a tax on your dividend if companies in the fund did not pay taxes.
Q: What about my investments in 401(k) and other retirement plans?
A: They would not be affected. You would have to pay taxes on the money — even if it is a tax-free dividend — when it is taken out.
Q: I hold shares of preferred stock. Do I benefit from Bush's plan?
A: Perhaps.
If the stock is 100 percent, genuine preferred stock — shares that generally pay handsome dividends and gives priority to shareholders if the company were to file for bankruptcy — you would get the tax break. But many preferred shares out in the market are hybrid preferred shares, experts say. These shares are treated like debt and their payments are considered interest, rather than a dividend. Such hybrid preferred shares would not get the dividend tax break. If you do not know what kind of preferred shares you hold, check with the company.
