Maboussin on Buybacks vs. Dividends

[txlaw]

You get last words.  People must be getting really sick of this thread. 

[ERICOPOLY]

Am I wrong about this?  If you provide more detailed hypotheticals, you can show me how I am wrong.

 

More details:

 

So let's say the controlling shareholder begins with 60% ownership in a $4b company.  

 

Here is the loop that repeats every quarter:

step 1)  The corporation buys back 0.25% of shares every quarter (on an annual basis 1% of shares are repurchased)

step 2)  At the end of the quarter, the controlling shareholder owns a higher percentage of the company than before.  He then calculates exactly how many shares, 'Y',  to sell to bring it back down to 60% ownership.

step 3)  He tells his broker to sell 'Y' number of shares over the following quarter

step 4)  go back to step 1

 

That would be a $24m annual income at a $4b market cap.  More income when the stock trades higher, less income when it trades lower.

 

He maintains intrinsic value -- his percentage ownership in the company never drops below 60%. The intrinsic value of the company at the start of the prior quarter is X.  He owns .60*X. The buybacks at the company make it such that his ownership goes up, but his selling brings it back down to 60% ownership.  So, after getting his laundered dividend, he still owns .60*X.  Thus, no impact to intrinsic value of his holdings -- but he has his laundered dividend in hand.  Oh, I suppose intrinsic value may have gone up over the course of the quarter due to retained earnings and such, but you get the point anyhow -- his ownership of the company is steady-eddy 60%.

 

Sometimes he will sell at higher or lower prices than the prior quarter's shares were repurchased at.  It doesn't really matter if in any given quarter the prices are not the same as in the prior quarter.  It won't always be higher, and won't always be lower -- over decades of consistent practice this washes out.  I suppose a really nit-picky person would say that he loses the time value of money for 3 months -- oh well, I can live with that criticism.

 

In the early years after his 60% takeover he may very well be selling some shares below his cost basis, taking a capital loss with his laundered dividend.  That would certainly be the case if I took over 60% of a company -- everyone would be rushing to dump the stock.  Over time perhaps he would succeed at growing the company and/or market confidence and the share price would rise, then perhaps his sales would be at 1x, 2x or 3x or 4x or whatever... relative to the cost basis of the shares.  Hard to say how long it would take before the dividend laundering advantage gets too watered down.  Even when the stock is a ten bagger there will still be a 10% discount on tax bill paid.  Once the share price gets exceedingly high (as it tends towards infinity), only then will txlaw be correct in his suggestion that equal tax rates on dividends and capital gains would eliminate the tax laundering scheme.  Gather ye rosebuds while ye may, I suppose...

 

Anyhow, my example above explains why I don't get upset when management uses cash to buy back shares at any price.  It's cheaper for me (in my taxable account) than when they pay a dividend.  Besides, I like to believe that I only own shares at good prices to begin with (and sell when they get expensive).

[Rabbitisrich]

I'm not sure that I understand your argument Ericopoly.

 

If the 60% owner gets his $24M dividend, he now owns $24M + .60($3.96B) vs. if he holds through the buyback and retains .606($3.96B). It's a wash before taxes (and all other costs... I'm also treating the buyback as a single event for convenience). If capital gains and dividend taxes are equal and unchanging through the holding period, you don't even get a tax deferral benefit.

[ERICOPOLY]

I'm not sure that I understand your argument Ericopoly.

 

If the 60% owner gets his $24M dividend, he now owns $24M + .60($3.96B) vs. if he holds through the buyback and retains .606($3.96B). It's a wash before taxes (and all other costs... I'm also treating the buyback as a single event for convenience).

 

This is right -- it's a wash before taxes.  

 

If capital gains and dividend taxes are equal and unchanging through the holding period, you don't even get a tax deferral benefit.

 

He doesn't need to buy back shares as a means of getting a tax deferral benefit.  For tax deferral he can use his retained cash flow to purchase 80+% positions in more companies.  He prefers to diversify the corporation's income anyhow: so rather than trying to boost his % ownership of the existing, he feels more secure to have the added diversification that new bolt-on 80+% acquisitions bring.  This is a passive investment vehicle.  He only looks for companies that run themselves (nothing to fix and management already in place) -- making new investments with the cash flow (without getting taxed on dividends before reinvestment) is one reason why he wanted a corporate investment vehicle in the first place.  He wants to acquire new companies without getting involved in running their operations -- just like you don't have to run companies that you own on a fractional basis.  Otherwise, he would get bogged down in the management.  So the focus is on passive investment here.

 

His only purpose in doing the buyback in the first place was as an alternative to taking the cash as a dividend.  100% of the alternative (a dividend) will be taxed, but not 100% of the value of the shares sold after the buyback (his cost basis in the shares is not zero -- he does not pay tax on the cost basis of shares he sells).

 

That's my point:  It all comes down to the cost basis on the shares sold -- because his cost basis is above zero on the shares, the tax will be less if he launders the dividend via buybacks instead of just paying out the dividend as cash.  In my prior post I mentioned that the taxes would only be the same if the share price approached infinity -- this is a reference to what you were taught in Calculus: "take the limit as N goes to infinity".  Think about how the Riemann sum was used to approximate the area under a curve using rectangles crammed together -- and to prove the integration (used to precisely compute the area under a curve), it was shown that cramming 'N' number (where N approaches infinity) of rectangles under a curve (where the width of each rectangle approaches zero) and then summing their respective areas will provide you with the area under a curve.  Somewhat similar type of thinking here -- as the share price heads towards infinity, the cost basis becomes insignificant (sorry, it's because I was a math major that I used this comparison.  I spent much of the time sneaking glances at Danica, so perhaps I didn't learn the subject matter very well; correct me if I'm wrong).

 

Once he has satisfied his need for personal cash flow via dividend laundering (to fund his personal spending), he is free of course to use more of the company cash for more buybacks if he wishes to boost his stake in the company.  That's a separate topic though -- that's just about boosting his ownership in the company without taking a dividend in order to do it.  "Best strategy for increasing one's ownership" is a separate topic from "extracting cash in a tax-friendly manner via dividend laundering".

 

[Rabbitisrich]

 

His only purpose in doing the buyback in the first place was as an alternative to taking the cash as a dividend.  100% of the alternative (a dividend) will be taxed, but not 100% of the value of the shares sold after the buyback (his cost basis in the shares is not zero -- he does not pay tax on the cost basis of shares he sells).

 

That's my point:  It all comes down to the cost basis on the shares sold -- because his cost basis is above zero on the shares, the tax will be less if he launders the dividend via buybacks instead of just paying out the dividend as cash.

 

 

 

 

 

That is a good point, but keep in mind that the dividend receiver's (DR) stock declines according to the pre-tax value of the dividend. If (DR) sells the stock and repurchases it immediately, the "loss" is added to the basis of the holdings. Assuming that all tax rates are equal and unchanging, and that appropriate income is available to offset the tax benefit, the benefit of t(new basis - old basis) should equal the cost of t(dividend), given that new basis is simply old basis + dividend.

 

The buyback strategy offers smaller transaction costs and less tax benefit/cost mismatch risk, but given certain assumptions it shouldn't offer significant benefits to the dividend. If you relax those assumptions, you can also create situations where a dividend provides a tax advantage. For example, when short-term gains pay a higher tax rate than dividends, a dividend receiver would benefit from using wash sales on short-term holdings of dividend paying stocks.

[ERICOPOLY]

If (DR) sells the stock and repurchases it immediately

 

1)  You are completely eliminating the tax deferral benefit on the retained earnings -- this is meant to be a tax-deferred investment holding company.  The annual tax-laundered-dividend payout in my example is only about 1%... but one can assume this holding company earns far more than that (it only buys back enough shares to fund his consumption and retains the rest of the earnings to reinvest).  The retained earnings over time push the stock price up -- but you keep turning it over every quarter at 100% so you are paying capital gains tax every quarter on those retained earnings and therefore on a quarterly basis paying far more in taxes than you'd pay if you just took a dividend in cash.  

 

example:  

Company compounds shareholder value at 10% annually.  With 100% turnover of the shares, you're paying 10x as much tax with your proposal versus just taking the 1% dividend.  And it's more than 10x the tax when compared to my dividend-laundered-buyback alternative with non-zero cost basis -- he is going to take the tax-deferral on retained earnings to the limit and leave his shares to his heirs with the step-up in cost basis.

 

2)  The person has a 60% stake in the company.  He can't sell and then immediately buy back a 60% stake.  For one thing (liquidity aside) he loses control of the company -- what if somebody doesn't sell it back?

 

 

 

ASIDE:

I was at a lunch yesterday with a local businessman (local to Sydney).  He says it's actually a zero personal income tax for Australian taxpayers for fully franked dividends on Australian shares (before I thought it was 9%).  Translation -- his maximum tax rate is 30% (paid by the corporation).  He can then pay out any post-tax corporate earnings to himself personally without getting taxed a second time.  This validates what my Australian grandmother says "The rich do not pay any tax".  In America they do at least pay some tax... not in Australia.  I believe the day the US Government gets serious about wanting more jobs in America, they will stop treating capital like it's something to be punished.

 

 

[Rabbitisrich]

If (DR) sells the stock and repurchases it immediately

 

1)  In your scenario the tax deferral benefits on the rest of the retained earnings are now zero -- this is meant to be a tax-deferred investment holding company.  The annual tax-laundered-dividend payout in my example is only about 1%... but one can assume this holding company earns far more than that (it only pays out enough to fund his consumption and retains the rest of the earnings to reinvest).  The retained earnings over time push the stock price up -- but you keep turning it over every quarter at 100% so you are paying capital gains tax every quarter on those retained earnings and therefore on a quarterly basis paying far more in taxes than you'd pay if you just took a dividend in cash. 

 

2)  The person has a 60% stake in the company.  He can't sell and then immediately buy back a 60% stake.  For one thing (liquidity aside) he loses control of the company -- what if somebody doesn't sell it back?

 

 

You're right, the wash sale scenario doesn't work. Without the wash sale rules, the only offsetting tax benefit is the dollar value of (t)(dividend) when you realize the capital gains in the future, so you've effectively paid all the interest on that money to the government.

 

How shitty is this deal?!

[ERICOPOLY]

If (DR) sells the stock and repurchases it immediately

 

1)  In your scenario the tax deferral benefits on the rest of the retained earnings are now zero -- this is meant to be a tax-deferred investment holding company.  The annual tax-laundered-dividend payout in my example is only about 1%... but one can assume this holding company earns far more than that (it only pays out enough to fund his consumption and retains the rest of the earnings to reinvest).  The retained earnings over time push the stock price up -- but you keep turning it over every quarter at 100% so you are paying capital gains tax every quarter on those retained earnings and therefore on a quarterly basis paying far more in taxes than you'd pay if you just took a dividend in cash.  

 

2)  The person has a 60% stake in the company.  He can't sell and then immediately buy back a 60% stake.  For one thing (liquidity aside) he loses control of the company -- what if somebody doesn't sell it back?

 

 

You're right, the wash sale scenario doesn't work. Without the wash sale rules, the only offsetting tax benefit is the dollar value of (t)(dividend) when you realize the capital gains in the future, so you've effectively paid all the interest on that money to the government.

 

How shitty is this deal?!

 

I added an "ASIDE" to my last post.  I am disheartened at our prospects of turning the US economy around as a jobs creation engine unless they cut the taxes on capital way back.

 

And that lunch conversation came up when he had just finished saying that BHP is buying back shares -- so I had to ask why in the hell BHP would buy back shares when Australian get the dividends tax-free???  I mean, Australian shareholders (in order to get their cash) will need to take a capital gain, where they will be owing tax... versus the tax-free alternative of just getting cash dividend!  Amazing -- what stupidity.  Must be that they are either trying to push up stock options or else they love their non-Australian shareholders a whole lot more.

 

[Myth465]

I am not a tax expert but whats to prevent this.

 

http://www.gurufocus.com/news.php?id=126662

 

In 1990 when Ian took over the management of PAT, the company's funds were only £5.5 million, most of which was Ian’s own money. When he passed away in 2008, nearly 20 years later, the company’s funds had grown to £160 million. In spite of its successful growth still a modest sum for such a successful investor.

 

Ian also overcame a problem most investment trusts and closed end funds have, of the shares always trading at a discount to their net asset value. Ian did this through share buybacks coupled to the issue of new shares when demand exceeded supply.

 

This is by far not the norm in the investment trust world where a share price discount of 25% is normal and 40% not unusual. But in a world where asset management companies get paid on the amount of assets they manage, buying back shares, thus lowering the assets they manage just does not happen.

 

----

 

Seems like the perfect way to avoid taxes and compound wealth but also stay very liquid. I am sure 15 guys on this board could pull enough funds to take over a closed end fund and perhaps install a manager of choice.

 

Thoughts?

[ERICOPOLY]

 

Seems like the perfect way to avoid taxes and compound wealth but also stay very liquid. I am sure 15 guys on this board could pull enough funds to take over a closed end fund and perhaps install a manager of choice.

 

Thoughts?

 

I like the idea of buying my own portfolio below NAV... but I'm wondering how we go about taking over a closed end fund.  You'd need to have knowledge of who the shareholders are so that you don't have someone else playing the same game (or just sitting on a big chunk and unwilling to sell at a reasonable price).

 

Why not start a new closed end fund instead of taking over an existing one?  I don't know anything about how hard it is to start one, so if that sounds naive I'll apologize in advance.

 

[Myth465]

I would be down to start 1 in a few years. I plan to put away whatever I have and live off my salary at some point. Pretty much spend all I make while my investments compound (outside of an emergency fund). Holding close end shares where I knew the Manager or had input on the fund would be ideal. I will look into this when I need a bit more tax planning. Hopefully my gains continue to compound in my  Roth vs. Taxable accounts.

[ERICOPOLY]

Curious why so many start partnerships instead of closed end funds?  It looks like partnerships lock out so many interested investors due to the SEC restrictions on net worth.

 

What is unattractive (from a money manager's perspective) about running closed end funds?  Why do you all do partnerships?  Is it something simple like, for example, trying to sell into an illiquid market that scares the investors away?  Are the expenses too high (sending material out to every fund holder)?  Do regulations make them bureaucratic nightmares?

[ericd1]

How to start one...

 

http://www.ehow.com/how_6827992_start-closed-end-fund.html

 

Certainly not an expert here but I would think a partnership is easier and less costly to start as well as operate (legal fees, IPO fees, no exchange listing fee etc). CEFs seem to be nice cash cows for their managers 

 

We could always buy controlling interest in a CEF and then liquidate it or turn it into a mutual fund and recoup the discount.

[Myth465]

Never mind, taxes flow through which defeats the purpose. I guess the Berkshire / Ericopolgy model is the best one. Either that or take over a company with a pension plan (and manage that to compound wealth tax free).

 

Distribution Policy

Like mutual funds, closed end funds generally do not pay tax at the fund level on amounts distributed to investors. The taxation is said to 'pass through' to the shareholders. Thus, since capital gains vary unpredictably, that practice makes dividend payouts equally unpredictable.

 

Consequently, some funds have instituted a managed distribution policy to make the distributions more stable. In those cases, the fund distributes a fixed percentage of its net assets regardless of its actual interest income and capital gains.

[ERICOPOLY]

There is also a "personal holding company tax" of 15% that your C corp has to pay on retained earnings from passive investments if you do not pay them out.  You can avoid it if the 5 largest shareholders put together comprise less than 50% of the shares, or if the majority of the corporate income is not from such passive investments.

 

Anyways, the suggestion that I just start my own corporation has this headwind to contend with.  And when in my example the man buys 60% of a company he should do so perhaps with an insurance company (more on that later) or an offshore company.

 

http://wraltechwire.com/business/tech_wire/opinion/story/2458989/

 

You can avoid the personal holding company tax if the corporation is offshore -- it only applies to domestic companies.  Also, if you acquire an insurance company or similar financial based business where the business model is designed around income from interest/dividends, then you do not have to worry about such a tax.

 

[Myth465]

Just do what the LUK guys did. Find a few partners. Shouldnt be too hard.

[ERICOPOLY]

Just do what the LUK guys did. Find a few partners. Shouldnt be too hard.

 

Cummings and Steinberg each own 10% of the company.  Were there more partners in the beginning?  Or did they reduce their ownership over time?

 

 

[Myth465]

Just do what the LUK guys did. Find a few partners. Shouldnt be too hard.

 

Cummings and Steinberg each own 10% of the company.  Were there more partners in the beginning?  Or did they reduce their ownership over time?

 

 

 

I believe they have been selling down throughout, but they also get options. I think they buy when cheap and sell when high. Also I think they bought whole companies vs. investing in partials. I would find a company, buy another company, and then trade with some of the excess capital, then buy another company - rinse and repeat.

[ERICOPOLY]

Just do what the LUK guys did. Find a few partners. Shouldnt be too hard.

 

Cummings and Steinberg each own 10% of the company.  Were there more partners in the beginning?  Or did they reduce their ownership over time?

 

 

 

I believe they have been selling down throughout, but they also get options. I think they buy when cheap and sell when high. Also I think they bought whole companies vs. investing in partials. I would find a company, buy another company, and then trade with some of the excess capital, then buy another company - rinse and repeat.

 

Probably also issued shared to make acquisitions.

 

They might have started with financial companies too (not sure).