For many years, dividends and share repurchases had very different tax consequences. The dividends that investors received were generally taxed at ordinary income tax rates. Therefore, if a firm paid $10 million in dividends, that payout would trigger significant tax liabilities for the firm’s shareholders (at least those subject to personal income taxes). On the other hand, when firms repurchased shares, the taxes triggered by that type of payout were generally much lower. There were several reasons for this difference. Only those shareholders who sold their shares as part of the repurchase program had any immediate tax liability. Shareholders who did not participate did not owe any taxes. Furthermore, some shareholders who did participate in the repurchase program might not owe any taxes on the funds they received if they were tax-exempt institutions or if they sold their shares at a loss. Finally, even those shareholders who participated in the repurchase program and sold their shares for a profit paid taxes only at the (usually lower) capital gains tax rate, (assuming the shares were held for at least one year), and even that tax only applied to the gain, not to the entire value of the shares repurchased. Consequently, investors could generally expect to pay far less in taxes on money that a firm distributed through a share repurchase compared to money paid out as dividends. That differential tax treatment in part explains the growing popularity of share repurchase programs in the 1980s and 1990s.

The Jobs and Growth Tax Relief Reconciliation Act of 2003 significantly changed the tax treatment of corporate dividends for most taxpayers. Prior to passage of the 2003 law, dividends received by investors were taxed as ordinary income at rates as high as 35 percent. The 2003 act reduced the tax rate on corporate dividends for most taxpayers to the tax rate applicable to capital gains, which is a maximum rate of 5 percent to 15 percent, depending on the taxpayer’s tax bracket. This change significantly diminishes the degree of “double taxation” of dividends, which results when the corporation is first taxed on its income and then shareholders pay taxes on the dividends that they receive. After-tax cash flow to dividend recipients is much greater at the lower applicable tax rate; the result is noticeably higher dividend payouts by corporations today than prior to passage of the 2003 legislation.

In early 2012, Congress passed the American Taxpayer Relief Act of 2012. For eveyone except those individuals in the newly established highest tax bracket, dividends and capital gains continue to be taxed at 15 percent. (For more details on the impact of the 2012 act, see the Focus on Practice box.)

Personal Finance Example 14.3

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The board of directors of Espinoza Industries, Inc., on October 4 of the current year, declared a quarterly dividend of $0.46 per share payable to all holders of record on Friday, October 30, with a payment date of November 19. Rob and Kate Heckman, who purchased 500 shares of Espinoza’s common stock on Thursday, October 15, wish to determine whether they will receive the recently declared dividend and, if so, when and how much they would net after taxes from the dividend given that the dividends would be subject to a 15% federal income tax.

in practice focus on PRACTICE: Capital Gains and Dividend Tax Treatment Extended to 2012 and Beyond for Some

In 1980, the percentage of firms paying monthly, quarterly, semiannual, or annual dividends stood at 60 percent. By the end of 2002, this number had declined to 20 percent. In May 2003, President George W. Bush signed into law the Jobs and Growth Tax Relief Reconciliation Act of 2003(JGTRRA). Prior to that new law, dividends were taxed once as part of corporate earnings and again as the personal income of the investor, in both cases with a potential top rate of 35 percent. The result was an effective tax rate of 57.75 percent on some dividends. Although the 2003 tax law did not completely eliminate the double taxation of dividends, it reduced the maximum possible effect of the double taxation of dividends to 44.75 percent. For taxpayers in the lower tax brackets, the combined effect was a maximum of 38.25 percent. Both the number of companies paying dividends and the amount of dividends spiked following the lowering of tax rates on dividends. For example, total dividends paid rose almost 14 percent in the first quarter after the new tax law was enacted, and the percentage of firms initiating dividends rose by nearly 40 percent the same quarter.

The tax rates under JGTRRA were originally programmed to expire at the end of 2008. However, in May 2006, Congress passed the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), extending the beneficial tax rates for 2 more years. Taxpayers in tax brackets above 15 percent paid a 15 percent rate on dividends paid before December 31, 2008. For taxpayers with a marginal tax rate of 15 percent or lower, the dividend tax rate was 5 percent until December 31, 2007, and 0 percent from 2008 to 2010. Long-term capital gains tax rates were reduced to the same rates as the new dividend tax rates through 2010. Although JGTRRA expired at the end of 2010, Congress extended the law until 2012 by passing the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.

At the onset of 2012, the pre-JGTRRA taxation of dividends would reappear unless further legislation made the law permanent. Those arguing to make the JGTRRA permanent pointed toward the weak economy and suggested that taxes needed to remain low to stimulate business investment and job creation. Others noted that the U.S. budget deficit was at an all-time high, so some combination of higher taxes and reduced spending was necessary to avoid economic problems associated with too much debt.

In early 2012, Congress passed the American Taxpayer Relief Act of 2012. For individuals in the 25 percent, 28 percent, 33 percent, and 35 percent income tax brackets, qualified dividends as well as capital gains continue to be taxed at 15 percent. However, for individuals with more than $400,000 in taxable income—and couples with more than $450,000—the rate increased to 20 percent. As was the case under JGTRRA, people in the 10 percent and 15 percent brackets, as before, will have a zero tax rate on dividends and capital gains.

 How might the expected future reappearance of higher tax rates on individuals receiving dividends affect corporate dividend payout policies?

Given the Friday, October 30, date of record, the stock would begin selling ex dividend 2 business days earlier on Wednesday, October 28. Purchasers of the stock on or before Tuesday, October 27, would receive the right to the dividend. Because the Heckmans purchased the stock on October 15, they would be eligible to receive the dividend of $0.46 per share. Thus, the Heckmans will receive $230 in dividends ($0.46 per share × 500 shares), which will be mailed to them on the November 19 payment date. Because they are subject to a 15% federal income tax on the dividends, the Heckmans will net $195.50 [(1 − 0.15) × $230] after taxes from the Espinoza Industries dividend.


Today, many firms offer dividend reinvestment plans (DRIPs), which enable stockholders to use dividends received on the firm’s stock to acquire additional shares—even fractional shares—at little or no transaction cost. Some companies even allow investors to make their initial purchases of the firm’s stock directly from the company without going through a broker. With DRIPs, plan participants typically can acquire shares at about 5 percent below the prevailing market price. From its point of view, the firm can issue new shares to participants more economically, avoiding the underpricing and flotation costs that would accompany the public sale of new shares. Clearly, the existence of a DRIP may enhance the market appeal of a firm’s shares.

dividend reinvestment plans (DRIPs)

Plans that enable stockholders to use dividends received on the firm’s stock to acquire additional shares—even fractional shares—at little or no transaction cost.


What happens to the stock price when a firm pays a dividend or repurchases shares? In theory, the answers to those questions are straightforward. Take a dividend payment for example. Suppose that a firm has $1 billion in assets, financed entirely by 10 million shares of common stock. Each share should be worth $100 ($1 billion ÷ 10,000,000 shares). Now suppose that the firm pays a $1 per share cash dividend, for a total dividend payout of $10 million. The assets of the firm fall to $990 million. Because shares outstanding remain at 10 million, each share should be worth $99. In other words, the stock price should fall by $1, exactly the amount of the dividend. The reduced share price simply reflects that cash formerly held by the firm is now in the hands of investors. To be precise, this reduction in share price should occur not when the dividend checks are mailed but rather when the stock begins trading ex dividend.

For share repurchases, the intuition is that “you get what you pay for.” In other words, if the firm buys back shares at the going market price, the reduction in cash is exactly offset by the reduction in the number of shares outstanding, so the market price of the stock should remain the same. Once again, consider the firm with $1 billion in assets and 10 million shares outstanding worth $100 each. Let’s say that the firm decides to distribute $10 million in cash by repurchasing 100,000 shares of stock. After the repurchase is completed, the firm’s assets will fall by $10 million to $990 million, but the shares outstanding will fall by 100,000 to 9,900,000. The new share price is therefore $990,000,000 ÷ 9,900,000, or $100, as before.

In practice, taxes and a variety of other market imperfections may cause the actual change in share price in response to a dividend payment or share repurchase to deviate from what we expect in theory. Furthermore, the stock price reaction to a cash payout may be different than the reaction to an announcement about an upcoming payout. For example, when a firm announces that it will increase its dividend, the share price usually rises on that news, even though the share price will fall when the dividend is actually paid. The next section discusses the impact of payout policy on the value of the firm in greater depth.


14–4Who are holders of record? When does a stock sell ex dividend?

14–5What effect did the Jobs and Growth Tax Relief Reconciliation Act of 2003 have on the taxation of corporate dividends? On corporate dividend payouts?

14–6What benefit is available to participants in a dividend reinvestment plan? How might the firm benefit?

14.3 Relevance of Payout Policy

LG 2

The financial literature has reported numerous theories and empirical findings concerning payout policy. Although this research provides some interesting insights about payout policy, capital budgeting and capital structure decisions are generally considered far more important than payout decisions. In other words, firms should not sacrifice good investment and financing decisions for a payout policy of questionable importance.

The most important question about payout policy is this one: Does payout policy have a significant effect on the value of a firm? A number of theoretical and empirical answers to this question have been proposed, but as yet there is no widely accepted rule to help a firm find its “optimal” payout policy. Most of the theories that have been proposed to explain the consequences of payout policy have focused on dividends. From here on, we will use the terms dividend policy and payout policyinterchangeably, meaning that we make no distinction between dividend payouts and share repurchases in terms of the theories that try to explain whether these policies have an effect on firm value.