I recently wrote an article about Bank of America's (NYSE:BAC) capital return plans following the release of the Federal Reserve's stress test and accompanying capital return plans earlier in March. I argued that I'd rather have share repurchases than a dividend increase and the reason for me is simple; I like share buybacks for a variety of reasons, not the least of which is that every other remaining share is instantly worth more than it was before the buyback. But an astute commenter, Jim388, raised the also important point of taxation in such a decision. In this article, we'll take a look at the differences in taxes in the buyback/dividend decision and what it could mean for you when selecting companies to add to your portfolio.
For this discussion, I'll use Bank of America as an example as it provides a perfect example of how a company can choose the tax fates of its respective shareholders simply by choosing how to return excess capital. BAC announced both an increase to its common dividend and a share/warrant repurchase authorization when it released its approved plans last week. Not only does the choice a company makes in terms of dividend, repurchases, or both have an impact on investor perception, etc., but it also has an impact on investors' taxes as well. BAC announced a dividend increase to 5 cents per share, which means that everyone that holds BAC in a taxable account will be subject to taxes on the 20 cents worth of cash dividends they receive each year. Whether they sell their shares or not is completely irrelevant; when you own something that pays a dividend, you owe taxes on it the year it is received.
By contrast, a buyback offers the added advantage of increasing the value of the shares that aren't bought back, but it also means that investors that continue to hold the stock realize that appreciation with zero taxes until the shares are sold. In addition, should a capital loss accrue to an investor's position, he will still owe taxes on any dividends received. If a loss accrues with buybacks only, there is no taxable gain or income. That is an important distinction, so let's take a look at an example in order to illustrate the point.
For this example, we'll assume an investor owns 1,000 shares of BAC at $17 per share. Before the dividend increase, that investor would be on the hook for taxes for four cents per share per year, or $40 per year. Assuming the investor is eligible for the 15% dividend tax rate, you're looking at $6 per year in taxes paid. Given the new dividend rate, that same situation will produce $30 in taxes per year. In this case, we're not talking about a lot of money on taxes - less than two tenths of a percent per year in terms of the value of the shares - but when the stock yields more, the amount can be a lot higher. As an aside, consider a stock that yields 4% under the same scenario; if BAC yielded 4%, holders would be subject to $102 in taxes per year on the same position.
Now, let's assume BAC didn't pay a dividend at all and instead used that money to buy back shares. BAC's 20 cent annual dividend on its ~10.5 billion shares means BAC is on the hook for $2.1 billion each year. If it instead used that money to repurchase shares, 123.5 million at $17 per share, it could reduce the float by ~1.2%. Let's assume in our simplified example that the share price increases by the exact amount of the repurchases, so shares are now trading at $17.20. In other words, we've simply swapped the 20 cents we would have received in cash for an increased share price instead. The net gain is the same, 20 cents, but the way it is achieved has changed.
But the other important difference is the taxation issue. Remember that if we received our 20 cents in cash, as BAC has decided to do, we owe $30 in taxes on our 1,000 share position. With the buyback scenario, we don't owe any taxes until we sell. Therefore, the buyback position actually produces a higher after-tax gain because you don't owe the $30 in taxes on your $200 gain until you sell.
Consider this same scenario over the next 5 years and the dividend scenario would produce a total of $1,000 dividends and taxes of $150 for a net gain of $850, assuming no further changes in the payout. The buyback scenario produces the same $1,000 in gains but without taxation; the after-tax gain is the same $1,000. Of course, you've got to pay taxes when you sell but in the meantime, you aren't paying taxes on dividends you're likely buying more shares with anyway. If you reinvest your dividends, you're not only paying taxes on the dividends, but you've got to pay transaction costs each time. With buybacks, you get the gains without having to pay premature taxes or transaction fees each time. And keep in mind this equation favors buybacks more and more as the yield goes up, as is widely expected with BAC.
This is a very, very simple example, but the point is to illustrate the difference between dividends and buybacks from a tax perspective. I personally prefer buybacks over dividends because it juices capital returns over the long term and mops up compensation-related dilution over time. Dividends are a nice one-time gain, but if you still like the company, you have to not only pay taxes but transaction costs if you reinvest. Bank of America has chosen to pacify both kinds of investors and return capital in both ways, which isn't exactly what I would have preferred.
This example illustrates the difference between capital gains and dividends for long-term investors. I prefer buybacks for a variety of reasons, but a big one is definitely taxes. Dividends are great for income but if you're holding for the long term, buybacks are preferential to avoid giving too much of your gains to Uncle Sam or your brokerage house.
Disclosure: I am long BAC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.