Dividends and Taxes

The dividend tax cut is not a simple issue. But this is a great start on the discussion. I would like to add a couple of things.

The efficient use of free cash flow discussion framework should include an element of what type of company, basically growth vs income, is involved. I would suggest that if you are a gold mine that dividends are a superior use of capital assuming you can find any other gold mines to buy or areas to mine. If you are a growth company, such as a plasma television equipment part manufacturer, dividends don’t make much sense as the free cash flow can provide a superior return by investing in more equipment and plant space as the life cycle of the product matures. Of course with any life cycle, maturity sets in and cash flow becomes more predictable, ala Microsoft, and dividends become more rational. But again that is based on the type of company and their goals and their point in the life cycle of development.

Also regarding dividends, stock options are also an issue, aren’t they? Employees with lots of options don’t want to see dividends as they reduce the capital gain of the stock and hence the value of the option plus they don’t pay dividends on the option shares unless exercised. Can a case be made that this issue will reduce the potential “microsoft” millionaires of the future and therefore reduce the number of new ventures that are started? A real hit to Silicon Valley, no?

Regarding taxation of dividends, I am not a CPA but my understanding of the tax code is that short term capital gains (less that one year) are taxed at the marginal tax rate, not a maximum of 20%. So you would have to hold a stock for one year to get long term (20%) treatment. However you point is very valid that you don’t pay capital gains unless you sell whereas dividends are taxed yearly at your marginal rate. So if dividends are tax free, why wouldn’t someone buy the day before they are paid and sell the day after? Although somewhat risky, many have made lots of money doing this and the elimination of the tax would surely increase it.

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