Avoid Falling Off the Fiscal Cliff with Special Dividends

by Jason Jenkins

Has there been a better political or economic “boogie man” than the fiscal cliff?

If Congress doesn’t play nice then the fiscal cliff is coming to get us all! But what is it exactly? Is this just some Beltway political game to score media points with both bases or will this have an affect on ordinary Joe American.

The sad thing about this mess is that its both. It’s a game of chicken where the stakes are the global economy. This situation we find ourselves in was actually created by our own politicians. The fiscal cliff is a dual edge sword that can send our economy into a temporary tailspin.

But there is a positive to the situation and the rise in taxes – many companies are issuing special dividends in the fourth quarter. Below I’ll explain what these special dividends are and how to look for companies that are most likely to pay them out.

But first, here’s what you need to know about this boogie man we know as “The Fiscal Cliff.”

The Taxman on Autopilot

If the President and Congress can’t meet in the middle, the fiscal cliff will be a number of automatic federal tax increases coupled with spending cuts starting January 1, 2013.

You’ll see the Bush’s tax cuts on income, investments, married couples, families with children, and inheritances all expire. Meanwhile, we have sequestration. That where automatic spending cuts will take effect totaling about $600 billion per year – $6.1 trillion over the next decade.

How did we get here? When Congress came up with the idea of the sequester, no one thought it would ever come to fruition. The cuts were set up to be so awful to each side of the aisle that no one would never let it get to that point. But it’s funny, only people outside of the “Beltway” see its true dysfunction. And now we are on the brink.

What’s Specifically At Stake

Increase in taxes

The Bush era tax cuts will expire December 31, 2012. They were living on borrowed time as they were set to go away at the end of 2010. But the President and Congress “kicked the can down the road” two years ago in a trade-off between the extension of unemployment benefits and a decision of no rate hikes across the income board.

If this happens, taxes will go up for the majority of us. More importantly to us savvy investors, this hike would apply to our earnings and investments (up to a possible 39.6%) and inheritance (up to 45%). Also, keep in mind that the payroll-tax cut of 2% and extended unemployment benefits would go away this year if no deal is reached.

The Alternative Minimum Tax: Silent and Deadly

What’s the Alternative Minimum Tax (AMT) you say? Well, if no deal is reached you’ll know as soon as you complete this year’s tax returns.

The AMT is like the ninja of the tax world. It sneaks up and attacks filers who have too many deductions and tax breaks. The idea behind it was to deter the very wealthy from not paying taxes at all. It would cut down on all the loopholes we hear the 1 percent get. However, now it affects a good number of the middle-class for two reasons:

  1. For some reason, it was not indexed for inflation and
  2. Bush’s tax cuts drove more of the middle class under the AMT’s domain.

Now, almost every year, Congress has to pass an AMT “patch” to exempt the majority that the tax affects. The last patch expired at the end of last year. If the government fails to reach an agreement, the AMT exemptions will go back to $45,000 for married couples and $33,750 for single filers. That could mean somewhere in the neighborhood of 28 million more households who would fall under the AMT for this current year.

The Automatic Cuts

As I stated before, this is a two-punch combination. The new year could bring with it a drastic cut in government spending. No matter what side of the aisle you’re on, there will be an immediate affect on the economy due to the speed and timing of them.

This is the ‘sequester’ you’ve heard so much about. It stems from Congress’ inability to deal with the raising of the government debt ceiling back in 2011.

The cuts touch everything but here are some of the highlights:

  • $55 billion reduction to next year’s defense budget,
  • Medicare would reduce payments by 2%. This includes a possible 30% in reimbursements to physicians
  • $55 billion worth of cuts to domestic programs

Here’s an equation you need to be aware of. An increase in taxes plus cuts in government spending equal somewhere around $800 billion being taken out of our economy in 2013.

The Congressional Budget Office (CBO) has forecast that if we hit the cliff, expect a recession in the first half of next year.  The numbers also show that growth would be cut by a half percent for the year but would make a comeback in the last two quarters of 2013.

An Introduction to Special Dividends

Here’s your introduction to special dividends. New legislation will force dividend income to be taxed at 39.6% – on top of that add an extra 3.8% due to the Affordable Health Care Act.

And with more than $2 trillion worth of cash in corporate America’s collective coffers, cash-soaked companies aren’t sitting on their hands idly waiting for Washington’s latest round of tax hikes.

Instead, they are handing their cash to shareholders in the form of special dividends.

You’ve heard the axiom before. There are just two emotions on Wall Street… fear and greed. The fiscal cliff has stirred plenty of fear. But the real story is the greed.

Since September at least 103 companies have announced a special end-of-the-year payout. One of the biggest announcements came last week when Sturm, Ruger & Co. (RGR:NYSE) made waves with tax-dodging payout worth nearly 10% of its share price.

But Costco (COST:NASDAQ) takes the top prize. The wholesale grocer announced a one-time payout worth more than $3 billion.

Stock Symbol Total Special Payout Payout Per Share
Costco COST $3.07 Billion $7.00
Las Vegas Sands LVS $ 2.26 Billion $2.75
Dillards DDS $235.5 Million $5.00
Sturm Ruger & Co. RGR $85.0 Million $4.50

An investment lesson we repeat often at Investment U is to always manage your portfolio with taxes in mind. The moves over the last 60 days prove that some of the world’s smartest companies are doing exactly that.

Special dividends can give you a dual edge windfall. First, you get the dividend before the tax rates go up. Then you can usually expect a bump in appreciation once the market is told the news.

So how can you find out who may be next to issue a special dividend? According to industry insiders, here are some of the characteristics special dividend payers are said to have:

  1. 25% of outstanding shares are owned by insiders.
  2. A greater than 5% free cash flow yield. That’s free cash flow per share /current market price per share. The higher the ratio the more attractive the stock.
  3. Debt-to-equity ratio is less than 30%.
  4. The company has a history of issuing special dividends.

Remember, no matter what happens in the market, there is always an opportunity to profit.

Good Investing,

Jason Jenkins

comments powered by Disqus