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If Dividends Become Tax-Free
The president's plan could change your investment choices.

This month, we're going to tackle the question that's currently on every investor's lips: "How will the Bush administration's proposed elimination of double taxation on corporate dividends affect my investments and my future investment choices?"

At first glance, the plan looks bullish for the overall stock market, but before we get into any specifics, we must remind you that we're dealing with a controversial proposal that's seen by its opponents as primarily a benefit for the rich. The Bush plan could be greatly modified or never become law at all.

Understanding the Basics

To understand exactly what's being debated here, we must first examine the overall proposal. Following are its basic elements:

• corporations will compute their taxable income, just as before
• the corporate tax liability will then be paid
• then, the "excludable dividend amount" (EDA), a new phrase used in the proposal, would be calculated. The EDA equals the taxable income less the tax paid. The EDA is the amount that can be distributed tax-free to a company's shareholders.

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For example, if a corporation's taxable income is $10 million and its tax liability is $3.5 million, the remaining $6.5 million can be distributed tax-free to shareholders.

Because many fast-growing corporations use all of their after-tax profits for capital reinvestment to expand their businesses, dividends aren't distributed to shareholders.

Under the proposal, if the EDA isn't distributed to shareholders as dividends, it's considered a "deemed distribution" and the amount is added to the tax basis of the shares each shareholder owns. In other words, if the EDA that's not distributed computes to $1 per share, then $1 is added to the cost basis of each share held by shareholders, just as if the dividend had been distributed and the shareholder reinvested the dividend the same day. The tax benefit to you, as a shareholder, would be realized when you sold the shares. Your tax basis would be $1 greater, so your gain subject to capital gains tax rates would be reduced.

Rebalancing Retirement Plans

In a qualified retirement plan or IRA, no tax is paid until distributions are made during retirement. If the Bush proposal is enacted, there would be no tax benefit in a qualified retirement plan or IRA for investing in corporations that consistently pay high dividends (so-called "income" stocks). In this case, you may want to rebalance your retirement plan portfolio and invest a higher percentage of assets in corporate bonds and stock of corporations that don't pay dividends, otherwise known as "growth" stocks.

Just the opposite would be true in your taxable accounts. In those accounts, you would consider investing more in corporations that consistently pay high dividends. The portion of your portfolio invested in growth stocks would be in your retirement plan, so your overall investment portfolio would be diversified -- and more tax efficient.

Investing in preferred stock, which tends to pay high dividends, may be worth consideration in your taxable accounts.

Reporting Could Be a Problem

The proposal requires corporations to report to shareholders (annually, on Form 1099-Dividend) the taxable, tax-free, and increase in basis component of the dividends received.

However, certain problems may exist in implementation. For example, corporations may have challenges distinguishing between dividends that had been taxed at the corporate level and dividends that came out of retained earnings.

Many unresolved issues exist regarding this proposal, so make investment decisions if and when the proposal becomes law. There remains a high level of uncertainty about whether this proposal, or some variation of it, will ever be enacted.

Richard J. Alphonso, JD, CPA/PFS, M.S.T., is president, and Anita S. Frank, CPA, is tax manager at The Financial Advisory Group, Inc., in Houston. The Financial Advisory Group {(713) 627-7660} provides personalized, fee-only financial planning, investment management and business consulting services.