Two weeks left to close out 2022… for taxes. Uncle Sam looks to finalize their share of earnings, income, royalties and gains. Many dread these final weeks wondering if the right box was checked, or if the rounding was right, or if a deduction has warranted. Almost every year, there is a news story about professional tax preparers arriving at different answers for the same set of facts. Could it be the tax system is too complex?
Though some taxes are silly, the reasons for other taxes are lost to time. One investment-oriented tax we need to be cognizant of is the Net Investment Income Tax (NIIT). This is a surtax levied on non-earnings income such as dividends, interest and capital gains, among others. NIIT was introduced as part of the Affordable Care Act (a.k.a. Obamacare) to pay for the startup and insurance costs. Many believed NIIT was initially temporary and certainly removed when the individual medical mandate was repealed, but the relic stands requiring extra consideration from accountants and investment professionals.
More recently, a discussion has entered the fold about raising the dividend tax rate. Didn’t we already have this debate? A little history and context are in order. Understandably, government wants to encourage business creation, research & development, and risk taking; hence, lower tax rates on long-term capital gains to encourage long-term investment. Also, prior to 2000, dividends were taxed as ordinary income. (Recall, dividends are a companies’ profits being distributed to shareholders after taxes had already been paid, so many consider this a double taxation… at the corporate level and the individual level.)
Recognized the difference between dividend tax rates and capital gains tax rates, companies realized investors could receive better after-tax returns via share buybacks versus paying dividends. Buying back stock shares would drive up the price of the stock prices, qualifying for lower capital gains tax treatment instead of dividends taxed at higher ordinary rates. Government acknowledged its tax policies heavily influenced managements’ capital deployment decisions. By making dividend and capital gains equal, government exited their unintended consequence. This historical relevance has escaped many, including Washington rule makers. The current call for taxing buybacks would result in a similar quandary.
Heavily used in 2022 is tax loss harvesting. Tax law reasonable allows losses to offset gains. However, investment professionals must be aware of the 30-day wash rule (a rule to dissuade tax loss harvesting even though tax law allows it), so the tax dance continues.
These few examples highlight the complexity that has built up over the years. Without the proper historical context, one policy creates another and another until the system is no longer recognizable with errant consequences. Calls for new taxation on buybacks or higher dividend rates will repeat historical unintended consequences. Historical context is often overlooked. Be careful what you ask for as historical lessons abound.
1Tax Foundation
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