Thursday, August 22, 2019

This Is Why Warren Buffett Prefers Dividends Over Capital Gains

Warren Buffett is the best investor in the world. He managed to snowball his networth from roughly $10,000 in the early 1950s to over 80 billion today. He has managed to compound net worth at high rates of return by investing in companies and industries that generate an ever growing stream of cashflows, and have low investment requirements.

Warren Buffett loves investing in industries and companies that distribute a lot of excess cashflows. Examples include:

Coca-Cola (KO), which is a dividend king with a 57 year history of annual dividend increases.

Wells Fargo (WFC), which is recovering nicely from the financial crisis, closing in on 9 consecutive years of annual dividend increases.

Apple (AAPL), which is one of the most valuable companies in the world, which has managed to reward shareholders with a dividend increase annually since 2012.

Warren Buffett is a closet dividend growth investor. While he doesn’t like paying dividends to Berkshire shareholders, he does like receiving them and being in control of how that cashflow is being reinvested. This is similar to the process ordinary dividend investors use in their portfolio activity.

But why does he prefer dividends over capital gains?

The reason for that is taxes.

For ordinary investors, long-term capital gains and qualified dividends are taxed at the same rate. If you are in the highest tax brackets in the US, you will pay a 20% marginal tax rate on qualified dividends and long-term capital gains.

If you are in the lowest tax brackets in the US, both qualified dividend income and long-term capital gains are taxed at zero tax rates. Being part of the capitalist class comes with hefty tax breaks, and lower tax rates, than being part of the working class.

For Corporations however, there are special rules regarding the taxation of dividends and capital gains.

Capital gains are taxed at ordinary income tax rates. In other words, when Buffett sells stock, he realizes a gain, which is taxed as ordinary income. It doesn’t matter if the gain is long-term or short-term in nature – it is not taxed at preferential rates. This is why Buffett doesn’t like selling shares, because there will be a large tax bite associated with this activity. There is an opportunity cost to selling a company, and replacing it with another that may not do as well as the original one too. As a result, it makes sense that he focuses on businesses that can grow earnings, values and dividends over the long run which he can hold on to for decades.

And here is the best part – corporations have a special tax break on dividend income called the dividend received deduction.

The dividend received deduction reduced the amount of dividend income, which is taxable by corporations that receive dividends from their stock investments.

A corporation that owns less than 20% in another company gets to be taxed only on 30% of the dividends received. In other words if Berkshire Hathaway owns 400 million shares of Coca-Cola stock, and that is less than 20% of the shares of Coca-Cola outstanding, it means that only 30% of that dividend income will be taxable. Berskhire Hathaway is generating $160 million in quarterly dividends from Coca-Cola every single quarter. This translates into $640 million per year, against a cost basis of $1.3 billion, for a 50% yield on cost. This means that only 30% of the $640 million will be taxable to Berkshire Hathaway. If we assume a tax rate of 35%, it means a tax of $67.2 million/year. This is roughly 10.50% tax on dividend income. If Berkshire were to sell Coca-Cola stock with a gain of $640 million today, they would pay tax of $224 million, which is four times as much as the tax on dividends.

A corporation that owns more than 20% in the stock of another, but less than 80%, is taxed only on 20% of the dividend income it receives from that investment. Assuming a 35% tax on income, it means that dividend income is taxed at an effective rate of 7%.

So when Berkshire Hathaway Energy, a subsidiary in which Berkshire Hathaway controls 90.90% of shares outstanding, distributes dividends to the parent company, they will be taxed at 7% at most.

A corporation that owns 100% of the stock in another company gets to avoid taxation on dividend income sourced from that company only. In other words, Berkshire Hathaway has generated over $2 billion in profits on its 1972 investment in See’s Candies. Since Berkshire Hathaway had a 100% interest in See’s Candies, it was not taxed on any dividends paid by See’s to Berkshire. Not only did Berkshire put only $25 million for the company in 1972, but it also paid no taxes on dividends in the process. When a corporation owns 100% of the stock in another corporation, its dividend income is taxed at an effective rate of 0%. This makes the process of moving money from one subsidiary into another, a painless and tax-free endeavor. Given the fact that Berkshire Hathaway is now more focused on buying companies outright, rather than buying stock on the market, this tax break is wonderful for the Omaha based conglomerate. If Berkshire were to sell any of the companies it fully owns today however, the gain on sale would be fully taxed at rates as high as 35% today.

Today we learned that Warren Buffett's Berkshire Hathaway prefers dividend income received from its subsidiaries over capital gains. That's because under the US tax code, dividend income is taxed more favorably than capital gains for corporations.

In my book however, this is another reason why Warren Buffett is a closet dividend growth investor.

Relevant Articles:

Warren Buffett – A Closet Dividend Investor
Warren Buffett on Dividends: Ideas from his 2013 Letters to Shareholders
Warren Buffett’s Dividend Stock Strategy
Dividends Provide a Tax-Efficient Form of Income

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