On Tax Strategy
By JANE J. KIM
Staff Reporter of THE WALL STREET JOURNAL
November 12, 2004
Investors who hope to play Microsoft Corp.'s coming special dividend to generate a short-term tax benefit are rooting for the stock to close slightly higher today. But depending on when they bought the stock, they could be disappointed.
Today is the deadline by which investors must purchase Microsoft in order to settle the transaction and receive the one-time $3-a-share dividend, which the company announced in July and which shareholders approved this week. The approximate $32 billion payout will be made on Dec. 2 to holders of shares of record Nov. 17.
The size of the dividend -- the largest in corporate history -- has generated interest among investors looking to "strip" the dividend, essentially gaining a qualified dividend taxed at a 15% rate while creating a short-term loss at a 35% tax rate.
In what may come as a surprise to many investors, however, a little-known tax provision may have already determined that the upcoming dividend is "extraordinary" -- a factor that severely limits investors' ability to essentially "strip" the dividend for those tax breaks.
Here's how it works: When the stock goes ex-dividend, a buyer of the stock is no longer eligible to receive the dividend and the stock price usually drops by the amount of the dividend on the ex-dividend date -- a date that falls before the dividend is distributed. That short-term loss could then be used by investors to offset any short-term gains in their portfolio.
If, however, a dividend is characterized as "extraordinary," then the loss is classified as a long-term capital loss -- up to the amount of the extraordinary dividend -- which would instead result in an offset of long-term gains.
Dividend stripping is less common today than it used to be. But for individuals, the strategy has become more attractive since the maximum tax rate on dividends fell to 15% last year, says Lehman Brothers' tax analyst Robert Willens. And as the tax law encouraged companies to issue larger dividends, the potential tax benefits generated by dividend stripping become more worthwhile, he adds. "There's been a lot of interest in this issue, as much as I've encountered," he says.
That explains why some investors are keenly watching to see what the closing price of Microsoft's stock will be today, the last trading day before the Nov. 15 ex-dividend date.
Under current tax laws, a dividend is usually classified as extraordinary if it is equal to or greater than 10% of the investor's cost basis in the stock, or the closing price of the stock on the last trading day before the ex-dividend date. This means that if the stock closes above $30.80 -- 10 times the $3 dividend plus the regular eight-cent quarterly dividend that Microsoft is also expected to pay out the same day -- then the dividend will not be classified as extraordinary and investors can therefore employ the tax arbitrage.
Shares of Microsoft have been trading in a steady range in the mid-20s since the company announced the dividend on July 20, but have edged higher in recent days. The stock closed at $29.98 yesterday.
But the other key date that some investors may have missed is Aug. 23, the ex-dividend date of Microsoft's last quarterly dividend. A little-known IRS rule states that, in cases where ex-dividend dates fall within a period of 85 days -- which is the case with Microsoft's upcoming special dividend and its August dividend -- the dividends must be aggregated and investors who have received both dividends may lose their eligibility to get the tax break.
The key date is the trading day before the first ex-dividend. On that day, Aug. 20, the stock closed at $27.20, making the dividend extraordinary for most investors.
Investors who bought after Aug. 23, however, may still be able to take advantage of that short-term tax break, says Edward Kleinbard, a partner at the Cleary, Gottlieb, Steen & Hamilton law firm in New York.
Write to Jane J. Kim at firstname.lastname@example.org
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