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| Decision 2004 |
When the Levies Break
Dwight Cass
09/01/2004
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How other potential tax increases should bear on our
decision making is somewhat less clear. The dividend tax, currently 15 percent,
is one example. Dividend-paying large cap stocks are becoming increasingly
popular as the economic cycle progresses from recovery to a more stable growth
period, in which large companies tend to outperform. If the dividend tax rate
goes up, this could affect the market value of these securities. However, we are
unlikely to witness a wholesale shift from dividend-paying securities to growth
or value stock due to tax changes; investors tend to decide among these options
based on their expectations of market performance, which is largely determined
by the economic cycle. “We have not yet seen people decide against
dividend-paying stocks because of the possibility of taxes,” says Robert
Seaberg, managing director of wealth planning and philanthropic services at
Smith Barney in New York.
| “If you are looking to change the risk profile of your asset allocation by
switching into stocks and bonds, then it is a good idea to do so now.” |
The income tax rate may also affect our portfolio
allocation decisions. If the rate rises, we may want to reconsider our weighting
of taxable versus tax-exempt debt, and reallocate our portfolios in favor of the
latter, which becomes more valuable, explains John Nersesian, managing director
of wealth management services at Nuveen Investments in Chicago.
To compare
the two, we need to calculate the tax-exempt debt’s taxable equivalent yield
(how much it would have to yield if it were taxable in order to be worth the
same as it is now on an after-tax basis). “If we look at a high quality annuity
today paying 3 percent, assuming a marginal tax rate of 35 percent, the taxable
equivalent yield is 5.38 percent,” Nersesian says. If taxes rise, that same
annuity will be worth more. “If we look at a 45 percent top income tax rate,
that same annuity yielding 3 percent provides a taxable equivalent yield of 6.36
percent. So the investor picks up, if you will, about a full percentage point in
terms of after-tax or taxable equivalent yield.”
| “A charitable contribution today, in a world of 35 percent marginal tax
rates, is less valuable than a charitable contribution I make next year or the year after, if tax rates were to rise to 40 or 50 percent.” |
Family Businesses With two out of five family companies expected to change
hands in the next half-decade, tax timing could become as important for business
owners and investors this year as it was in 1992. “On the family business side,
we are hearing and seeing a number of folks doing partial or full liquidity
events now, rather than waiting,” says Smith Barney’s Seaberg. He says these
individuals are taking an extraordinary distribution through the sale of all or
part of their businesses, believing that the combination of a low-tax tax
environment and the benefits of the economic recovery enables them to command a
higher price for their assets—and retain the lion’s share of it after taxes.
“The odds of things getting better are not very good,” he warns.
This has not
turned into a stampede, however, because many business owners who might have
sold during the 2001-2002 recession now view their companies as much better
investments. “If you’re in a business that’s going to benefit from this
recovering economy, you may want to wait to sell, because the value of the
business may go up far more than what you would have to give up by paying a
little more in capital gains tax,” notes Bill Carter, president of Carter
Advisory Services in Dallas.
| “We are hearing and seeing a number of folks doing partial or full liquidity
events now, rather than waiting.” |
If we have already negotiated to sell our family
business, or to bring in a partner (such as a private equity firm), we may wish
to bring the payment forward to avoid any potential tax increases. If we have
negotiated installment payments, we may want to accelerate or front-end the
installments as much as possible.
Tax concerns may also play a part in the
growing interest in leveraged recapitalizations. In a leveraged recap, a
business owner takes equity out of his or her company’s capital structure,
usually through a dividend, and replaces it with debt. Rising interest rates may
be one reason to undertake a recap—business owners want to lock in a lower cost
of capital—but the current dividend tax level is another. If we anticipate the
need to take some capital out of our family business and fear that dividend
taxes may rise under the next administration, this may be a good time to
consider one of these transactions.
Concentrated Stock Positions Many of us
find ourselves with much of our value tied up in a single stock, perhaps after
we take our company public or sell it to a firm that pays us in its own shares.
Of course, this subjects us to both liquidity and market risks. We may find
ourselves unable to obtain the liquidity we need for other investments or to
support our lifestyle, and we are dangerously overexposed to the fortunes of the
one company. Also, from an investment perspective, holding one stock is usually
a poor bet. The volatility of an average stock is three times that of a
diversified large cap portfolio, and high-volatility assets grow more slowly.
(Of course, those who have owned Microsoft stock since its IPO may beg to
differ! However, generally speaking, this is true.)
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