Long-time readers know that the way to tell if a financier is lying about stock buybacks is to check if their mouth is moving.
But since buybacks are back in the news, meaning lies about buybacks are back in the news, I thought I’d offer a quick refresher.
If buybacks and dividends are identical, why do buybacks at all?
The lie about buybacks always starts the same way: “from a corporate finance perspective, share buybacks and dividends are identical.” This concept of identity is extremely important to people lying about share buybacks.
The logic goes that a firm with more cash than it is able to productively invest in operations should return some or all of that cash to its shareholders. Since a single share contains the value of the firm’s productive capacity and any cash and marketable securities it has on its books, minus debt, buying back shares (increasing the proportional ownership of the firm’s productive capacity for the remaining shareholders) and issuing dividends (moving cash from the books of the company to the individual accounts of shareholders) should have the same effect as buybacks on the company (less cash) and the shareholders (more cash for the shareholders who participate in a buyback, or a greater ownership stake in the operating business for the shareholders who don’t). Hence, the identity that’s so important to people lying about buybacks.
So if this identity holds, if share buybacks are absolutely identical in every way to dividend distributions, why all the fury around banning them?
Stock buybacks are about managing individual shareholder tax liability
The fury is because dividends and share buybacks aren’t identical: when held in taxable accounts, dividends are taxed in full in the year they’re distributed, while only people who participate in share buybacks incur a tax liability, and only if their shares have increased in value since purchase.
That means dividends create a “blended” tax rate across all shareholders (a 0% rate for tax-free institutions and individuals, a 23.8% rate for high-income individuals), while share buybacks allow shareholders to determine their own tax liability.
In a stylized example, a firm issuing a $1 per share dividend on 1,000,000 shares is virtually guaranteed to distribute some of it to untaxed institutions or individuals in the 0% capital gains tax bracket, some to individuals in the 15% tax bracket, some to individuals in the 20% tax bracket, and some to individuals in the 23.8% tax bracket, while a firm buying back $1,000,000 worth of shares might not create any individual tax liability at all, if only untaxed institutional shareholders participate in the buyback.
Should wealthy shareholders decide for themselves whether to pay taxes?
This is the whole ballgame. Since only the very wealthy hold shares in taxable accounts at all (as opposed to workplace retirement, IRA, or HSA accounts), the entire propaganda operation around share buybacks is focused on allowing them to manage their individual tax liability. A lifetime of carefully selecting companies that maximize their share buybacks and minimize their dividends leaves a multi-millionaire paying virtually nothing in taxes, then passing along greatly appreciated shares with a stepped-up basis to their heirs.
As I explained in my earlier post, 364 days a year financiers have no trouble explaining this in fine detail to their wealthy clients. But on the 365th day they begin to rant and rave about how there’s absolutely no difference between dividends and buybacks.
But the debate over share buybacks has never been about corporate finance. The debate is about whether the wealthiest people in the country should get to decide for themselves if they’ll ever owe taxes on their investment returns, or whether those returns will be passed from generation to generation tax-free.
I’d mostly agree but note that in the case of a dividend, there is actual cash going to recipient (so they have funds to pay the tax) which is not the case for a buyback (unless the shares are sold). We don’t want to force recipient to have to sell shares so maybe any change in tax treatment of stock buyback should be targeted at a certain AGI.
I think a better approach would be to get rid of step=up in basis which isn’t really needed now that cost basis is being reported to the IRS. There is still some tax deferral but at least you avoid the issue of gain never being taxed.
wolf,
Why don’t we want to force recipients to have to sell shares?
—Indy