Tax Man Cometh - Where Will All That Dividend Money Go?

Margie is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

In a recent Motley Fool blog article Richard Saintvilus suggested that Apple (NASDAQ: AAPL) is right to hold onto its monster hoard of cash ($111 billion and counting) rather than to give into investor demands and payout a massive special dividend following such companies as Oracle and Las Vegas Sands which have prepared to, or already issued large payouts to shareholders.

Of course, the reason we are seeing a rush by companies to issue excess capital to shareholders is because President Obama has stated he intends to roll back the Bush-era tax-cuts on capital gains which currently stands at 15%, and it might land up at the 40% range next year.

Obviously management is looking out for their shareholders, trying to save them money that if paid next year would likely end up in government coffers, but the question that both myself and Richard had, though we differ a little in our answers, is this the best use of corporate cash?

The Purpose of Dividends For Investors

First off, with all the accounting shenanigans out there, dividends generally prove that a company has the ability to generate positive cash flow and that you haven’t invested your nest egg in a full blown Enron. Secondly, many investors rely on these dividends to pay their monthly bills- having invested for yield. So why don’t companies pay out all cash flow as earnings?

Well, a company that is paying out 100% of its cash flow obviously isn’t going to be growing. In fact, the greater the percentage of cash flow paid out in the form of dividends, the less management expects, or even can, grow its business.

So, companies that are growing rapidly won’t be shelling out generated cash to shareholders because management believes it can be put to better use and generate a higher return.

What To Do?

Now, Mr. Saintvilus argues that companies with large cash hordes like Google (NASDAQ: GOOG), Microsoft (NASDAQ: MSFT), and Apple would be better off using the capital to purchase companies that will result in greater long term gains for shareholders, specifically mentioning Google’s possible purchase of Pandora  (NYSE: P) as an example. For the record, I could honestly see that happening, as Google has the user base and traffic to rapidly expand Pandora’s audience, and Pandora is the perfect avenue to introduce its user base to Google Play as it attempts to take on iTunes.

Now, returning back to Apple, with their $111 billion in cash, an amount which dwarfs the value of 90% of public companies several times over, saying they need all that money to grow is a little like Scrooge McDuck with his piles and piles of gold saying he can’t lend you $10 cause he needs it buy lunch.

So am I saying Apple should issue a special dividend? No, I have a suggestion that I believe will be a growing trend for all US companies- share buybacks.

For those of you who don’t understand share buybacks, a company uses their money to buy its shares on the open market and retire them. So if a company had 100 shares outstanding, and the CFO used corporate funds to purchase 10% of the shares (10 in this case) these shares would be retired and now the company would have 90 shares outstanding. The next quarter earnings would be divided by the 90 shares outstanding, instead of 100, and if you owned 1 share of the company, rather than owning 1% your stake would be 1.11% …

The downside of share repurchases:

1)  It is an excellent accounting maneuver for CEO’s and CFO’s to manipulate reported earnings

2)  Less than scrupulous execs use the share buybacks as a way to support the stock price while they sell their options, thus fleecing other shareholders.

3)  Despite having all the inside info, many corporations have purchased shares at very high prices rather than low. If the share price declines, obviously the money expended was used poorly. No less than Warren Buffett blames this on CEO's "outsized egos."

The Positive

The main positive, and the reason demi-God Warren Buffett favors them: You avoid the tax man. That’s right, a corporation doesn’t pay taxes directly on share repurchases and thus the capital is preserved in the value of the shares until they are sold on the open market. This is one of the reasons Buffett holds positions for literally decades.

The Tax Man Cometh

So my prediction is fairly obvious. As the US Government raises taxes on dividends we will see more and more share buybacks. We will also likely be seeing dividends slashed.

Microsoft began issuing dividends in part because of the change in how dividends are taxed. The same is definitely (not probably) going to happen in reverse as corporations respond to the disincentive of paying out cash to shareholders.

And finally back to Apple. Based on current valuations, as a shareholder, I’d much rather see the company buy back stock if they believe it to be cheap, then get a lump sum the tax man would take a slice of. I’ll pay those taxes when I sell my Apple shares.

Bottom Line

Look for yields in the stock market to drop, fewer dividend raises, more slashed, and more share buybacks as management responds to the new tax laws. And whatever Apple does, I’m sure Tim Cook is looking out for shareholders’ interests.

margiecfl has long positions in Apple, Google, and Microsoft. The Motley Fool owns shares of Apple, Google, and Microsoft. Motley Fool newsletter services recommend Apple, Google, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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