The Excess Tax Paid by Sellers represents the tax savings an investor can earn if they wait to receive a qualified dividend payment instead of selling before a distribution and therefore earning their income in the form of a short-term capital gain.
For a last holder of record system to function, accrued and unpaid financial distributions are added to the value of the security. We call this the “distribution premium.” This backward and harmful accounting practice increases the value of a security, causing buyers to purchase fewer shares. It can also cause some sellers to pay more taxes than they should owe.
Adding unpaid distributions to the value of a security is an archaic way of delivering income to sellers. It is inefficient as well as harmful. In a last holder of record payment system, income is not paid via distributions to sellers. It is delivered via price appreciation.
For example, on the first day of a 90-day payment period, you buy an investment fund for $100.00 per share. For this example, we will assume the values of the securities held by the investment fund do not move. Over the payment period, the income-producing securities owned by the investment fund are paying lots of dividends, that are paid to the investment fund. When the investment fund receives these distributions, instead of booking them as liabilities, because they know they must pay the distributions at the end of the payment period, they book them as assets, increasing the fund’s net asset value (NAV). Let’s assume the fund will distribute a $1.00 per share dividend, and halfway through the payment period, $.50 of the $1.00 has been earned from dividends paid by the fund’s holdings and accrued to the NAV. This fund is now trading at $100.50 per share, of which $100.00 represents the underlying value of the securities the fund owns, and $.50 represents the earned but unpaid dividends.
If you wish to sell your fund halfway through the payment period, you will receive the $.50 in income earned via the security’s price appreciation. You might think, well, this is ok with me. However, you must consider the tax consequences of earning your income in the form of a capital gain (aka price appreciation) vs. waiting to be paid the income in the form of an actual income distribution, which can be taxed favorably when compared to capital gains.
This is why understanding your distribution types and holding periods is essential.
Let’s look at why holding periods matter. In the example above, the investor will sell their shares after owning them for 45 days, and they will receive their distribution in the form of a capital gain instead of an actual dividend.
Since the investor held these shares for less than one year, the investor will pay short-term capital gains tax rates on their distribution that was earned as a capital gain (security price appreciation). However, if the investor held their shares and sold them after the actual dividend was paid, the income distribution would be taxed at a substantially lower qualified income tax rate because this investor met the holding period requirement of 61 days and is therefore entitled to a lower qualified income tax rate (remember the payment period was 90 days and the investor bought the shares on day 1).
Assuming this investor’s state and federal tax rates for short-term capital gains and qualified income are 40% and 20%, respectively, then here is how to calculate the after-tax return in both scenarios assuming 1,000 shares were purchased.
1) $.50 in income earned as a short-term capital gain (1,000 X $.50) X (1-.40) = $300.00.
2) $.50 in income earned as a qualified dividend distribution (1,000 X $.50) X (1-.20) = $400.00.
Therefore the investor who waits to receive an actual dividend vs. taking their income as a capital gain will increase their after-tax income distribution by 33%, which is substantial.
These tax savings occur when the following conditions are met:
1) the seller has owned the security for at least 61 days at the time of sale and less than one year.
2) the income distribution qualifies as qualified income distribution. For more on what qualifies as a qualified and ordinary income distribution, please see the article titled “What is the Difference Between an Ordinary Loss and a Qualified Loss.”
These tax savings will add up over your lifetime. Always check the Excess Tax Paid By Sellers calculation to see if you can make more money by waiting to sell your shares and receiving an income distribution instead of earning your income via price appreciation.