(By Mani) Over the past several months, investors have been closely monitoring the upcoming "fiscal cliff" situation as well as the capital deployment activities of corporations in various sectors.
So, what exactly happens to both individuals and corporations if the Bush era tax cuts go away on January 1, 2013 and why are so many corporations rushing to make these changes in the fourth quarter?
First, as it relates to individuals, the 10 percent tax bracket will go away and will be replaced by 15 percent. The 15 percent bracket will remain unchanged, the 25 percent bracket will move to 28 percent, the 28 percent bracket will move to 31 percent, the 33 percent bracket will move to 36 percent, and the 35 percent bracket will move to 39.6 percent.
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"We note these are the rates that were in effect prior to 2001, or before the Economic Growth and Tax Relief Reconciliation Act of 2001 (included the "Bush tax cuts")," RBC Capital Markets analyst Glen Novarro said in a client note.
Originally, the Bush era tax cuts were set to expire in 2010, but they were extended through 2012 by the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010.
Also, if the Bush era tax cuts go away, there will be a marriage penalty, a phase-out of itemized deductions for individuals with adjusted gross income (AGI) above $175K, a phase-out of personal exemption deductions for individuals with AGIs above $175K ($265K for married joint filers), and increases in many other taxes such as estate tax, gift tax, generation-skipping tax, etc.
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"In effect, tax rates will move higher for all individuals, not just the wealthiest 1–2% of Americans," Novarro noted.
If Bush Era Tax cuts go away, the maximum tax rate on dividends will increase to 39.6 percent from 15 percent while the long-term capital gains tax rate will increase to 20 percent from 15 percent.
Separately, both dividend tax rates and capital tax rates are set to move higher if the Bush era tax cuts go away on Jan. 1. The current maximum federal tax rate on dividends and long-term capital gains are set at 15 percent for income tax bracket over 25 percent while the minimum federal tax rate on dividends and long-term capital gains is 0 percent for income tax bracket of 10 percent or 15 percent).
Additionally, the minimum federal tax rate on dividends will increase to 15 percent for the lowest income tax bracket of 10 percent from 0 percent. Also, the minimum federal tax rate on long-term capital gains will increase to 8 percent or 10 percent for the lowest income tax brackets of 10 percent and 15 percent.
There is an increase in the number of companies that are paying a special dividend in the fourth quarter of 2012, ahead of potential U.S. tax changes.
Meanwhile, a survey of 100 public companies by Markit, a financial information services company, suggested that about 38 percent of companies surveyed reported a likelihood of a special dividend in the fourth quarter of 2012.
Recall that the Bush tax cuts were originally set to expire at the end of 2010, and the market did not see a material increase in special dividends being announced until the November 2010/December 2010 timeframe. Markit estimated that about 74 companies across various industries declared special dividends in the fourth quarter of 2010, up from the normal average of about 31 companies.
There are many examples of companies that have recently announced a special dividend or moved up their quarterly dividend in front of potential U.S. tax changes. Several recent examples include AOL, Inc. (NYSE: AOL), Brown-Forman Corp. (NYSE: BF-B), Buckle, Inc. (NYSE: BKE), Costco Wholesale Corp. (NASDAQ: COST), Walt Disney Co. (NYSE: DIS) and Wal-Mart Stores, Inc. (NYSE: WMT).
"When we took a look only at the abnormal returns from the companies that announced special dividends, we found an abnormal return of +3–5% on the day following the announcement," Novarro wrote.
Accordingly, there could at least a short-term, tradable investment strategy around finding companies that could potentially announce a large special dividend between now and year-end.