Stock dividends are in jeopardy on multiple fronts.  This is not good news for equity income investors or the US stock market overall.  Four forces are converging on and against US dividends:

• Companies are cutting dividends or not raising them
• Tax trap in existing dividend tax rules
• Congress will legislate higher dividend taxes after 2008
• Possible legislative mandate for TARP participants to suspend dividends.

The delicate condition of investor psychology, the simple math of dividends as part of total return, and the comparative yield opportunities in developed foreign markets, suggest that declining dividends would depress US stock prices.

Implications:

If US stock (SPY, IVV) dividends decline, bonds (AGG, IEF, MUB) would become relatively more attractive.  Foreign developed market stocks (EFA, VEA) would become relatively more attractive.

Simply put, US stock prices would decline.

Dividend oriented funds (DVY, VIG, SDY) would possibly suffer most. Foreign developed market dividend focused funds (IDV, DWM) would possibly be more attractive than US dividend funds, although they would suffer the same tax problems as US dividend funds.

Company Dividend Actions:

WSJ, Oct 21:

“The prospects for dividends remains extremely cautious,” added Mr. Silverblatt [senior index analyst at S&P], specifically highlighting financials. Nonetheless, he noted more than half of all dividend-paying S&P 500 members expected to boost outlays in 2009. Among them won’t be General Electric Co., which recently announced plans to not hike its dividend in 2009 for the first time in 33 years.

CNN, Oct 27:

… the recent surge in dividend cuts could accelerate as more companies run into financial trouble. S&P on Oct. 21 reduced its estimate for the collective annual dividends paid this year by S&P 500 companies by 80 cents per share from $28.85 to $28.05.

S&P also expects total dividends paid by S&P 500 companies for the fourth quarter will drop 10 percent, to around $60 billion from $67 billion in the fourth quarter of 2007, the biggest year-to-year decline since 1958. Some fear more companies will feel free to cut dividends now that a trend has set in.

Wall Street Journal, Oct 29:

More real-estate investment trusts are expected to sacrifice their dividends as broader market turmoil drains their liquidity and hinders debt refinancing.

LaSalle Hotel Properties said last week that it cut its annual dividend by 51% to provide $100 million in liquidity over the next 26 months. The hotel REIT, whose shares have fallen more than 70% so far this year, is considered to be in the vanguard.

… Rich Moore, an analyst at RBC Capital Markets, said REITs aren’t being rewarded for their rich dividends amid dramatic stock-market declines. “I think you are going to see more [dividend cuts] because they can take the money and pay off debt,” he said.

Current Dividend Tax Trap:

Market Watch, Oct 21:

If a dividend-paying company fails to make a profit this year amid the financial turmoil, and consequently doesn’t pay federal income taxes, dividends that investors take as cash could be taxed at a 35 percent rate rather than the typical 15 percent for so-called qualified dividend income, Silverblatt [senior S&P index analyst] said.

New Dividend Tax Rates:

If Obama wins, which seems probable, and if the Congress becomes controlled by Democrats, which seems possible to probable, the favorable tax treatment of both dividends and capital gains will be reduced.  Some talk is of reclassifying dividends as ordinary income, and ordinary income tax rates will rise too.

That would be bad for stock prices, and worse for equity income stocks and their investors in particular.

Possible Congressional Mandate to Suspend Dividends:

There are trial balloons going up in Washington about a possible ban on financial companies from paying dividends if they receive government aid under TARP.

The financial sector accounts for about 15% of the S&P 500 market cap, and generates high yields compared to the other sectors. If major banks stopped paying dividends, the yield on the S&P 500 would decline significantly more than it would otherwise. That would probably have strong negative impact on stock prices.

Washington Post, Oct 30:

“The whole purpose of the program is to increase lending and inject capital into Main Street. If the money is used for dividends, it defeats the purpose of the program,” said Sen. Charles E. Schumer (D-N.Y.), who has called for the government to require a suspension of dividend payments.

Bloomberg, Oct 31:

House Financial Services Committee Chairman Barney Frank said banks using cash from the $700 billion U.S. rescue plan for bonuses, acquisitions and other purposes unrelated to lending are in “violation” of the law.

“I am deeply disappointed that a number of financial institutions are distorting the legislation,” Frank, a Massachusetts Democrat, said in a statement today. “Any use of these funds for any purpose other than lending — for bonuses, for severance pay, for dividends, for acquisitions of other institutions, etc. — is a violation of the terms of the act.”

Senators Dodd and Sanders intend to take steps to limit uses of bailout money for bonuses and to extend government powers to reclaim money without the need for bankruptcy, if the money is not used as intended. They are only talking about executive compensation for the moment, but if the “no-dividends” idea is blended in, the outcome will not be good for US stocks.

Bloomberg, Oct 31:

“When you invite the government into your living room, which is what you’re doing with the TARP program, I can’t guarantee you they’re going to be a good guest in your house,” said Gerard Comizio, senior partner at Paul, Hastings, Janofsky & Walker LLP and former deputy counsel at the Office of Thrift Supervision. “This program is basically a work in progress.”

Richard Shaw
QVM Group LLC

The bailout of Wall Street may not have ultimate costs as high as the nominal bailout amount, but the interest payments on the debt will come due immediately, and the recoveries from Wall Street, if any, will take many years.

The impact of the bailout which will surely happen in one form or the other, will impact taxes, interest rates, the exchange rate of the Dollar, imports and exports, foreign direct investment both in and out of the US, corporate sales and profits, and a long list of economic and investment dimensions too long to mention and to unknowable to predict.

You can bet that your investments will be heavily impacted — fixed income (proxies AGG and IEF), domestic equities (proxies SPY and VTI), international equities (proxies EFA and EEM), real estate (proxy VNQ), commodities (proxies DJP, USO and GLD), currencies (proxies UUP and UDN) and other types of investments will all be impacted.

It’s too soon for us to come up with investment or disinvestment recommendations we’re willing to publish.  However, one big factor in how things play out is the size of the tab for the bailout on a per investor basis.

We’ve noodled some costs we’d like to share with you here.

Per Taxpayer Annual Costs:

Who will pay how much and for how long for the bailout?

With the assumptions below, how much would taxpayers in each bracket have to pay per year for 30 years to support the debt service on the bonds issued for the bailout, assuming 30-year amortization of a sinking fund?

• if the total bailout is $1 trillion (the prior $300 billion already paid out, plus the $700 billion proposed to be paid out),
• and if the money is borrowed by the US using 30-year Treasury bonds,
• and if the interest rate is the 4.13% rate for 30-yr bonds today
• and if taxpayers are burdened to the same degree that they currently pay taxes
• then WOW!

The annual cost per average taxpayer is $439, but the distribution among income segments is tremendously skewed.

The bill for the top 1% of taxpayers is a shocking $173,000 per year.  The annual bill for the bottom 50% of taxpayers is an easy $27.  The image below shows the annual cost for the following income segments of taxpayers based on 2005 tax demographics from the IRS:

• top 1%,
• top 5%,
• top 10%,
• top 25%,
• top 50%
• bottom 50%.

click image to enlarge

Good luck to us all.

P.S. We don’t know all the history behind mark-to-market accounting rules, but wouldn’t temporarily creating more asset valuation flexibility in this locked-up credit market improve capital ratios and reduce the capital infusion requirements, reducing the size of the needed bailout, and grease the wheels of credit a bit?

Recording assets at cost can be a fiction, but under extreme conditions such as we have today, recording assets at “market” can also be a fiction.

Mark-to-market becomes fictional when the bids and bid sizes are so low that the assets can’t or won’t be sold.  Mark-to-market is based on the assumption of a functioning market, which we do not have at this point.

There is a fundamental difference between loss of worth and loss of liquidity.

At this point, government talk without action may be making markets less liquid.

If a bank holds assets with low bids and has the expectation that the government may agree to buy those assets at a higher price, the bank will delay sales to wait for the higher government bid.  In effect, the government, not the banks, may be causing the credit market liquidity problems by promising but not delivering relief.

Richard Shaw
QVM Group LLC

Now that the primaries for both US political parties are over, it is time for investors to begin to evaluate the likely tax change scenarios under the new government that will soon be installed.

All signs are that taxes will rise, but how much and in what ways will differ depending on who is president and which party controls the House and the Senate.

None of the changes are likely to be favorable to investors in general. Accordingly, there will probably be shifts in what is more or less attractive to investors, with resulting changes in money flow and returns for types of investments. Company behavior may change as well.

For example, dividends are a case in point. After the tax laws changed to reduce taxes on dividends, equity income became more popular, several high-yield funds were launched, and companies increased dividend payouts.

If dividends taxes are increased, there may be a shift toward capital gains which can at least be deferred until a position is closed.

If that becomes the situation, higher yield sectors such as utilities and financials may become less attractive while lower yield sectors such as technology may become more attractive. Companies may also reduce the rate of growth of dividends and commit more funds to stock repurchases.

That is one example, but there are many possibilities.  Here a few more:

The prospect of carbon taxes introduces an extraordinary wild card in the tax mix. How that would percolate through the economy is uncertain, but likely dramatic.

Now is the time for investors to think about the probabilities and to formulate plans to adjust portfolios appropriately when the tax changes become clear and imminent.

Richard Shaw
QVM Group LLC

[securities mentioned in this article: VTI, IVW, SPY, TLT, IVW, XLE, IHF, BND, EFA, DVY, MUB, IVE, PUW, IBB]

Summary:

In the words of Tony Soprano: “Fogetaboutit”.

Expanded Summary:

In the words of the IRS: “Section 1091“, “Section 267” and “Rev Ruling 2008-5”

Purpose:

All investors and their investment advisors, should have an understanding of the Wash Sale Rule and related rules before making investment decisions, instead of learning about them painfully from their accountants at tax filing time.

This article is about where we stand as investment advisors on the important Wash Sale Rule with respect to schemes to circumvent the 30-day exclusionary period with alternate investment accounts such as:

• IRA accounts
• 401-k accounts
• other self directed tax qualified accounts
• sole owner limited liability companies
• sole owner S or C corporations
• revocable living trusts
• marital joint taxable accounts
• spouse’s individual taxable accounts
• children’s accounts

Disclaimer:

This article is for discussion purposes only and is not personal or specific “tax advice”. We are investment advisors, not tax accountants, tax lawyers or tax advisors, but we are able to read, and the reading seems clear. You should read the IRS materials and draw your own conclusions, or rely on the guidance of your personal tax advisor.

Discussion:

The Wash Sale Rule contained in IRC Section 1091 says that an investor (who is not a dealer) cannot deduct the realized loss on investment if the investor made a “substantially identical” investment within the 30-day period before or after the date of the realized loss.

We wrote about whether or not substitute investment funds are “substantially identical” in two prior articles (August 11, 2007 and May 20, 2008).

“Substantially identical” is not defined in the regulations, but general consensus could probably be found with something like:

Substantially identical means the same in all important respects, particularly economic position and risk exposure, but not correlation of return, except for the case of two companies undergoing merger or the case of one security convertible to another.

This article discusses the use of multiple accounts of different types in relation to the Wash Sale Rule.

Rev Ruling 208-05: The most common alternate account scheme involves harvesting a loss in a regular taxable account, immediately buying the same security in an IRA (and perhaps then 31 days later closing the IRA position followed by re-opening the position in the regular account).  

Blogs and forums have many references to this approach. The general responses to questioners are essentially “maybe that would work, and probably the IRS wouldn’t find it” or “it probably doesn’t work”.  

The IRS dealt with that scheme in January of 2008 with Revenue Ruling 2008-05, which flatly closes the door on the approach.  

Key language from that ruling is as follows:

“ISSUE
If an individual sells stock or securities for a loss and causes his or her individual retirement account or Roth IRA to purchase substantially identical stock or securities within 30 days before or after the sale, is the loss on the sale of the stock or securities disallowed?”

“HOLDING
The loss on the sale of stock is disallowed under § 1091.”

There are no current reporting requirements in place for taxpayers, brokers or fund companies to assist the IRS in finding Wash Sales involving an IRA, but we do not recommend tempting fate. We’ve all been put on notice by the Revenue Ruling. Someday, we may find one more new form to complete at tax time to deal with that issue.

One might argue that the IRA (or any other tax qualified account) changes the economic position and risk exposure of the investor by converting all gains and dividends to ordinary income, and by making capital losses within the IRA non-deductible. However, we’ve got better things to do than to argue with the IRS about that, and probably so do you.  

Bottom line, you cannot use an IRA of any kind to circumvent the Wash Sale Rule.  

The ruling does not say, but surely an IRS auditor would likely take the position, that use of a 401-k or other self-directed retirement plan to substitute a substantially identical holding is also not an acceptable way around the Wash Sale Rule.

Side Note: An interesting question might arise if an employee was making regular monthly purchases of employer stock in a 401-k, while also holding shares in the employer’s company in a taxable personal account, and selling some of those taxable account shares at a loss. It seems that it would be disallowed by the logic of the ruling, but it also seems to be a quite different set of facts and circumstances.  Perhaps there may be a ruling on that someday too.

Section 267: Related Party Transactions: Other wash sale avoidance schemes might involve harvesting a loss in a regular account and immediately buying the same security in a trust for which you are the beneficiary, or in a solely owned LLC or an S or C corporation, or in a joint marital account, a spouse’s individual account or a child’s account.  Well – ”Fogetaboutit”.

Section 267 says,

“You cannot deduct your loss on the sale of stock through your broker if, under a prearranged plan, a related party buys the same stock you had owned.”   

We’re not exactly sure what the larger term “pre-arranged means”, but we are comfortable that it includes intentionally selling security “A” in controlled account XYZ and purchase of security “A” in controlled account ABC within the 30-day exclusionary period before and after the sale of security “A” in account XYZ, where you or your family benefit by both accounts.

There may or may not be some alternate structure that you can identify that the Related Party Rule of Section 267 does not specifically list, but the intent of the IRS is clear – If you control both accounts and benefit from both accounts, or the nature of the transaction is intra-family, they are related parties and you can’t use them to avoid the Wash Sale Rule.

Conclusion:

Unless you find good sport in baiting the IRS and spending your time and money arguing points with them or the tax court, be satisfied that there is no way around the Wash Sale Rule with alternate accounts.

Perhaps someone with a mega-loss and mega-wealth will find good occasion to challenge some aspect of these rules, but if you lose hundreds, thousands or even tens of thousands of dollars, your time and money is better spent seeking similar, but not substantially identical, substitute investments in the same account where you incurred the loss.  We discuss working rules for viable substitutions in another article.

Richard Shaw
QVM Group LLC

The practical challenge when tax loss harvesting is maintaining a continuous asset class exposure at target levels without time gaps, while avoiding penalties under the IRS Wash Sale Rule (IRC Section 1091).

The problem with time gaps is that significant market moves can occur in the 30-day waiting period of the Wash Sale rule, which would prevent the portfolio from achieving the risk and return expectations on which the portfolio asset allocation was designed.

The solution to the problem is substitution. Immediately upon realizing a loss in one fund, open a position in an alternate fund that is similar to, but not “substantially identical” to, the fund on which the loss was realized.

After the waiting period of 30 days, close the substitute fund position and reopen the original position (assuming the alternate fund is a second best choice). Or, if the substitute fund is equally attractive for the portfolio purpose, keep the substitute position and make the original your new alternate substitute for use with a potential future tax loss harvest.

Importance of a Standby Substitution List:

You should develop a tax harvesting fund substitution list now, not later. To do it right, you need some time to identify prospects, research their particulars (including whether they have enough liquidity), and make a determination as to their suitability for your purposes and for Wash Sale Rule compliance. You won’t have time for that if you try to do it on the fly when you decide to realize a loss. Make the list when you have time to do it well.

Here is a sample of a list for some key asset classes.

The problem with advice. You should consult your tax advisor. Everybody says that. Your stock brokerage or mutual fund company says that. The IRS help line says that. And, we say that — although we are not afraid to tell you what we think, so long as you don’t act on it without running it by your tax advisor.

There is a high probability that your tax advisor will bounce you back to your stockbroker or mutual fund company. That’s because the regulations are vague. Unless you manage a wide path around the Wash Sale Rule, your tax advisor may not know enough about the particular investments you are using to say with comfort whether or not they comply.

The solution to the tax advisor problem is preparation. We are investment managers, not tax advisors, but we know far more about the investment funds in our portfolios than our tax advisors. If you are managing your money, you should know more about your investments too.

If you understand the Wash Sale Rule principals and terms, and you have done thorough research on your investment funds, you will be in a good position to present your logic to your tax advisor, who will then be able to apply tax expertise to your investment fund knowledge to make appropriate decisions.

We recommend establishing guidelines with your tax advisor to be used before you invest, rather than debating the issues on a transaction basis after you invest.

What’s in this article?:

This article explores solutions for fund-based portfolios, and provides you with some of the preparation and ammunition to have the necessary informed discussion with your tax advisor.

Better yet, we recommend presenting a list of funds and their “not substantially identical” substitutes to your tax advisor to achieve a higher level of comfort with your compliance. We present some examples in this article that we feel are compliant.

Summary of the Wash Sale Rule:

A tax loss deduction is disallowed if, in the 30-day period before or after a realized loss, the investor replaces the security on which the loss was realized with another security that “appears” to be “substantially identical”.

IRS Publication 550 discusses the Wash Sale Rule and provides some examples, but does not discuss or provide examples for investment funds.

“Appears” from the statute is not defined (and is not mentioned in Publication 550). Obviously the burden of proof is on the investor, which means the investor should be well armed with fund characteristics and attributes to argue the matter of “appearances” if a deduction is challenged by the IRS.

Publication 550 says this about “substantially identical”:

“In determining whether stock or securities are substantially identical, you must consider all the facts and circumstances in your particular case. Ordinarily, stocks or securities of one corporation are not considered substantially identical to stocks or securities of another corporation. However, they may be substantially identical in some cases.”

As you have just read, “substantially identical” is not defined — investor beware. However, based on the opinions of a variety of tax experts, who in turn have relied on case law, we think a general consensus could probably found with something like:

Substantially identical means the same in all important respects, particularly economic position and risk exposure, but not correlation of return, except for the case of two companies undergoing merger or the case of one security convertible to another.

In the end, we think the arguments will revolve around differences in your “economic position” and “risk exposure” between investing in the original fund versus investing in the substitute fund. Be prepared to argue those differences.

Conservative Substitution Working Rules:

In an earlier article examining tax loss harvesting as it relates to the IRS Wash Sale Rule, we concluded with this set of working rules for replacing a fund during the 30-day exclusionary period before and after the date of the realized loss to satisfy the question as to whether there is the “appearance” that the funds are “substantially identical”:

1) Replace one actively managed fund for another if the issuers and managers are not the same.

2) Replace one index fund for another index fund, even though there may be overlap in their holdings, if the index of the sold and of the purchased fund are not the same index, and the differences between the indices are obviously significant (e.g. either they have a significantly different number of index constituents or they hold the same constituents but in significantly different proportions).

3) Replace any index fund with any actively managed fund regardless of issuer

4) Replace any actively managed fund with any index fund regardless of issuer.

5) Ask your “personal tax adviser” if they agree before adopting these working rules — no statement in this article is personal tax advice.

In the graphic above, the type “A” Substitutes for the Example Original funds all comply with these working rules. We think of them as conservative substitutes, because we believe they neither “appear to be” nor are they “substantially identical”.

Those substitutes in comparison broadly represent the asset class of the originals they replace, but they:

• are sponsored by different investment management firms
• track different indices
• reflect that the indices have different numbers of index constituents or formula proportions of constituents
• have different management expense ratios
• yield different cash distributions (except for the commodity funds with no distributions)
• hold different numbers portfolio positions
• hold different proportions for all or most of the holdings they have in common.

For these reasons, we think the examples given are highly defensible, because of the number of differences and the obviousness of their significance to the “economic position” and “risk exposure” associated with them.

Aggressive Substitution Working Rule:

We think it should be possible to use a substitute fund that has the same index benchmark target as the original fund, if the “facts and circumstances” show the funds to be nominally the same, but factually different.

The first obstacle to this aggressive approach is the superficial “appearance” of being identical. The second obstacle is how much difference the IRS will require to accept that the two index funds are not substantially identical.

This area is untested and the issues are not obvious to someone who does not delve into investment details. That makes it aggressive (risky). It’s got to be tested sometime, so we’ll start the debate now with this article.

Here is the aggressive rule, after which we will explore factual issues for some pairs to see the spectrum of difference and no-difference that can exist:

Replace one index fund for another index fund offered by different sponsoring companies, but each based on the same index, if the way the two funds pursue the same index is not substantially identical in terms of attributes such as:

• index representative sampling versus replication
• major differences in the number of holdings used for representative sampling
• management expense ratios (and sales or redemption loads, if any)
• cash distribution yield of income and of capital gains
• unrealized gains
• portfolio turnover rate
• use of derivatives versus no use of derivatives to track index
• credit quality, average duration or maturity for bond funds
• valuation ratios (such as P/E, P/B, P/S, and P/CF) for equity funds
• position weights of largest portfolio holdings

The Case of Four Pairs:

Let’s look at a spectrum of four pairs of funds each tracking the same index to see how differences can be found:

1. SPY : IVV
2. EFA : VEA
3. VWO : EEM
4. BND : AGG

SPY : IVV

This pair is substantially identical. They would not work for substitution under the Wash Sale Rule. They both track the S&P 500 index. They both use replication (each holds all 500 constituents in exact index weights). They have negligible differences in expense ratios. All of the portfolio characteristics are therefore essentially identical as are distributions. [number of different attributes = 0]

EFA : VEA

This pair may not be substantially identical, although they are close the edge. Their greatest differences are in expense ratio (reflected directly in yield), the number of holdings and the weight of “Other/Not Classified” holdings. [number of different attributes = 4]

VWO : EEM

This pair is not substantially identical when you look into the portfolio attributes. They have different average market-caps, different P/CF, massively different expense ratios, different yields beyond the effect of expense ratios, different weights in the top 10 holdings, different regional weights, and different numbers of holdings. [number of different attributes =7]

BND : AGG

This pair is not substantially identical in terms of portfolio attributes. While they both use representative sampling, the difference between 172 portf0lio positions and 11, 930 is enormous (and the risk of tracking error is greater in one than the other). The average effective maturity is different and the average credit quality is different (both classical indicators of relative risk). The weight of positions in the top 10 is widely different. The SEC yield is different. The expense ratio of one is nearly double the other (expenses being extra critical to outcomes in a fixed income fund). The distribution of bond holdings by credit quality is different. [number of different attributes = 7]

Conclusion:

If you stick to the conservative working rules, you should have a fairly short meeting with your tax advisor. If you want to use the aggressive rule, arm yourself with plenty of data and be prepared to receive a larger invoice for professional services rendered.

If you have other views on the matter, please do comment as we all learn about this uncharted area together.

Richard Shaw
QVM Group LLC

[securities mentioned in this article: VTI IWV ISI EFA FEZ VPL IEV VEA EEM EEB BIK VWO VNQ IYR ICF DJP GSC BND IEF AGG ]