It sounded so simple at first. President Bush wants to eliminate the federal income tax on corporate dividends, so the smart move for Washington investors this year was supposed to be to buy stocks that pay healthy dividends.
But since details of the plan began to dribble out last week, taking advantage of the president's proposal looks a lot more tricky.
The deeper you dig into the White House proposal and the harder you look at local stocks, the more difficult it is to find companies in the District, Maryland and Virginia that might benefit from the plan.
Most of the local stocks that pay large dividends would not be eligible for the tax break. The best payouts come from real estate investment trusts (REITs) and business development companies (BDCs), which wouldn't qualify for the exemption from taxes on dividends because they already get special tax advantages.
The dividend tax exemption itself may prove to be far less significant to Washington investors than the other tax break that is hidden in the president's proposal -- a cut in the capital-gains tax rate on stocks of profitable, tax-paying companies.
"Profitable, tax-paying companies" is a key qualifier. They are the only kind that would be eligible for either the lower capital-gains rate or the dividend tax exemption.
That rules out virtually the entire Washington high-tech community. Dividends are unheard of in high tech, even for profitable companies. Profits are practically nonexistent in biotech and are a recent phenomenon for many other technology companies. The losses that tech companies run up before they break into the black can be carried forward and deducted from future profits. Most high-tech companies here have so many millions of accumulated losses that it will be years before they have to pay income taxes.
Picking stocks that might qualify for either lower capital-gains taxes or exemption from the tax on dividends is probably premature anyway.
Congress hasn't even started discussing the president's tax proposals, let alone gotten into the slicing and dicing that is part of every new tax law. Chances are that what actually passes will look nothing like what is now on the table.
Doing away with what's often called "double taxation of dividends" was the goal announced by the president. Companies pay corporate income taxes on their profits. Then when they pass on part of their after-tax profits to shareholders as dividends, the shareholders pay personal income taxes on them.
The essence of the Bush plan is that stockholders won't have to pay taxes on dividends, if the corporation paying the dividend has already paid federal income taxes on that money.
The hidden surprise in the White House proposal is that there is also a capital-gains tax break for investors in companies that have after-tax profits that are not distributed as dividends. This bonus was slipped in because the administration does not want to favor companies that pay dividends over those that retain their earnings and reinvest them.
The process for figuring this break is so complicated that even accounting experts and investment managers acknowledge that they don't understand quite how it would work or, more important, how much it might cut the capital-gains tax on stock profits.
But in principal, the White House proposal would reduce the capital-gains taxes on investments in profitable, tax-paying companies that steadily build up their retained earnings. If they also pay a nice dividend, so much the better -- stockholders would qualify for both tax breaks.
No companies fit that description better than Fannie Mae and Freddie Mac, the two government-chartered mortgage companies that are Washington's biggest financial institutions. Both have been stellar long-term investments, and they would be even more appealing under the plan proposed by the president.
"Fannie and Freddie will look very attractive," said Paul J. Miller, the senior analyst at Friedman, Billings, Ramsey who follows the two companies. "If my crystal ball told me this was going to pass tomorrow, I would be talking these stocks up a lot."
Fannie Mae pays a quarterly dividend of 33 cents a share, which comes to a 1.9 percent annual yield based on Friday's closing stock price of $68.65. Freddie Mac pays 22 cents a share quarterly, a 1.4 percent yield with the stock selling at $63.20.
Though Fannie Mae is often criticized for not paying D.C. taxes, its profits are taxed at the federal level, as are Freddie Mac's. So that is not an issue.
Both "have a lot of retained earnings," Miller noted. And while they do pay dividends, "they have very low payout ratios" compared with their total profits. "They could easily ramp up their dividends and the stocks would really move" if the president's plan passes, Miller said.
The local stock that pays the highest dividend yield -- aside from the REITS and BDCs -- apparently will not qualify for the exemption from taxes on its dividends.
Bethesda-based USEC, previously known as U.S. Enrichment, processes fuel for nuclear power plants. USEC didn't have to pay corporate income taxes last year, its financial reports show, so its dividend would be taxable.
Too bad. USEC pays a quarterly dividend of 13.75 cents a share -- 55 cents a year -- and its stock is trading for just $6.49 a share, a yield of just under 8.5 percent.
Today, Washington investors seeking dividend income look mostly to local utility companies, banks, the two dozen REITs based in the region and the handful of BDCs headquartered here.
Operating under special provisions of the federal tax codes, REITs and BDCs are exempt from income taxes as long as they distribute most of their profits to stockholders as dividends. There is no "double taxation" because only the stockholders pay taxes now. If REIT and BDC dividends were tax-free, there would be a double tax exemption, so they are specifically excluded from the Bush proposal.
Unlike the dividends paid by other companies, which are a fixed amount per share per quarter, the payouts from REITs and BDCs vary from quarter to quarter, depending on their profits. In discussing dividends, it's important to understand what is meant by "dividend yield." That is not simply the annual per-share dividend paid by a stock. It is the per-share dividend stated as a percentage of the current stock price. The dividend yield goes down when the price of a stock goes up, even though the actual amount of the dividend doesn't change.
Today the dividend yields on some local REIT stocks are so large that at first glance, it doesn't matter whether their shareholders have to pay taxes on them. FBR Asset Investment of Arlington is yielding more than 15 percent, Cornerstone Realty Income Trust of Richmond almost 14 percent. Even after paying one-third of that in taxes, investors still earn more after-tax income than they can get on any local company whose dividends would be tax-free under the Bush plan.
BDCs, which get the same tax break as REITs but invest in small businesses instead of real estate, also pay taxable dividends that few firms eligible for the exemption are likely to match. Look at MCG Capital of Arlington, yielding more than 15 percent; American Capital Strategies of Bethesda, yielding nearly 11 percent; and Allied Capital of Washington, yielding about 9.5 percent.
But many analysts fear that if the federal tax on dividends is abolished, the REIT industry will suffer. With new opportunities to earn tax-exempt dividends, REITs will become less attractive to investors, they predict. The most negative REIT critics are already urging investors to sell.
It is also uncertain how ending the tax on dividends would affect the market for bank and utility stocks, which have long been viewed as reliable sources of dividend income for individual investors.
There are dozens of smaller banks in Maryland and Virginia that pay regular dividends in the range of a 2 to 3 percent yield. Bigger yields are available from some larger banks. The stock of Baltimore-based Provident Bankshares yields about 3.7 percent. Bank of America yields almost 3.6 percent, and BB&T yields 3 percent.
Utility stock yields are even better. WGL Holdings, the parent of Washington Gas Light, yields 5.2 percent. Pepco yields a little less than 5 percent. Dominion Resources, the big Virginia utility, yields 4.5 percent.
Over the years, utilities have raised the capital they need to build their power plants, electric grids and pipelines by issuing a finely tuned mix of stocks and bonds. If the tax on dividends is abolished, the capital structure of the utility industries would undoubtedly change. But how it might evolve is impossible to predict.
Fundamentally, the dividends paid by utilities depend on how much investors demand to be paid for letting the utilities use their money. Would investors be willing to take less if their dividends were tax-free? Probably, so utility yields could fall.
How the financial markets would adjust to eliminating the tax on dividends is the great unanswerable question raised by Bush's proposal.
Over the past century, delicate balances have evolved among many kinds of investments. The interest rates on corporate bonds, which pay taxable interest, affect the interest rates on municipal bonds, which pay tax-free interest. The tax-free yields on low-risk municipal bonds are connected to the tax-free yields on high-risk REIT stocks. The dividend yields on utility stocks are related to the interest yields on utility bonds. Increases and decreases in interest rates and the overall level of the stock market can change all these relationships and dozens of others.
The architecture of this elaborate matrix surely will be altered if Congress does away with the tax on dividends. No one on Wall Street or in Washington has figured out how, least of all the people in the White House who came up with the idea.