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More and more attention is being focused on dividend stocks as low fixed income interest rates keep setting new records and investors search desperately for alternatives. In analyzing dividend stocks, it is important to be aware of certain tax and regulatory considerations that affect the performance of various equities.

As to the tax issue, the author is not a tax accountant or tax attorney and the article is not intended to provide advice to any reader concerning the preparation or filing of a tax return or concerning tax planning. With respect to the detailed tax issues arising from investments, readers are advised to consult with a tax professional.

Probably the most important distinction with respect to different types of dividend stocks involves special provisions of the Internal Revenue Code. Under these provisions, real estate investment trusts (REITs) and regulated investment companies (RICs) are provided with special tax rules not generally applicable to other corporations. In very general terms, these rules provide that REITs and RICs can avoid paying corporate income tax if they pay out at least 90% of their earnings as dividends. The dividends paid to shareholders are then generally taxed as ordinary income to the shareholders (it is possible that some of the dividends may be taxable as capital gains or not taxed at all because they are treated as a return of capital). This makes the RIC or REIT a kind of pass-through entity with respect to earnings and tax liability.

In addition to possible effects on the shareholders' tax liability, these regulatory provisions affect the nature of investment expectations. Whereas most corporations retain a large percentage of their earnings and use those retained earnings to invest in expansion or acquisitions (or increasingly, in share repurchases), RICs and REITs generally pay out a very large percentage of earnings as dividends and therefore do not have the ability to retain substantial earnings to spend on expansion or acquisitions. Thus, a REIT like Annaly Capital (NYSE:NLY) can provide a dividend of nearly 14% but will not tend to grow as steadily as a plain old company (POC) like McDonald's (NYSE:MCD), which can retain earnings and invest those retained earnings in expansion.

Most investors are familiar with REITs - I have written previously about the different kinds of mortgage REITs and about equity REITs as well. RICs are primarily Business Development Companies (BDCs) such as Ares Capital (NASDAQ:ARCC) and Prospect Capital (NASDAQ:PSEC). BDCs tend to make business loans and employ limited leverage to increase their returns. Like REITs, BDCs find it hard to retain earnings.

Investors will notice that REITs and BDCs can grow but that they frequently do it by engaging in secondary offerings of stock. These offerings can affect the share price and/or the book value per share. As a general matter, REITs and RICs try to avoid engaging in secondary offerings at prices below book value but sometimes the need for additional capital makes these offerings unavoidable.

All of this means that REITs and RICs are less likely to be able to produce consistent increases in per share dividend levels or in per share price over time. Because growth in the enterprise generally involves an increase in the number of outstanding shares, it is very difficult to produce consistently increasing dividends per share. Of course, REITs and RICs can increase (and decrease) dividend levels due to the performance of their underlying investments and other factors affecting earnings. Equity REITs can have periods of substantial price appreciation if rents and real estate values are increasing. And there are times when a REIT or a RIC has a very depressed share price, which can provide an investor with an opportunity to achieve large capital gains in a short period of time. I have made the case that MCG Capital (NASDAQ:MCGC) and American Capital (NASDAQ:ACAS) fall into this category currently. But it would be very unusual to see a REIT or RIC increasing per share dividends consistently over a long period of time the way a POC stock like Coca-Cola (NYSE:KO) has done or to experience the kind of explosion in price per share experienced by Apple (NASDAQ:AAPL).

Utility Stocks (UTEs - the best performing sector last year) have their own peculiarities. Traditionally, the electric and gas utility industries were regulated as to entry and price. This meant that companies in the industry were protected from competition by exclusive service territory provisions. It also meant that regulators at the state level controlled the prices utilities could charge and, therefore, limited the potential for rate increases. In recent years, the sector has experienced more competition and price flexibility. As a general rule, UTEs pay out a relatively high percentage of earnings as dividends and increase their dividends steadily but very, very slowly. Thus, the Dow Jones Uitlity Index continued increasing its dividends throughout the Panic of 2008-09, but the sequential increases have been very small.

These differences make comparisons between companies in different sectors very difficult. As a general matter, POCs offer more long-term prospects for price appreciation than REITs, RICs or UTEs. UTEs tend to steadily increase dividends whereas REITs and RICs may see substantial dividend reductions from time to time because they do not have the "cushion" of a low payout ratio. No one of the sectors is "better" than the others; it all depends upon the investor's objectives and, of course, the entry price.

Disclosure: I am long NLY, KO, MCD, AAPL, ARCC, PSEC, MCGC, ACAS.

Source: Comparing Dividend Stocks: REITs, RICs, POCs And UTEs