How the U.S. Taxes Stock Buybacks and Dividends

Companies have two primary tools to reward their shareholders with company profit: stock buybacks and dividends. Stock buybacks, also known as share repurchases, occur when a public company buys shares of its own stock. A dividend is when a company distributes profits to shareholders in the form of cash or additional stock. In theory, companies conduct stock buybacks or pay dividends when they have exhausted other investment opportunities.

A company may choose to repurchase shares rather than pay dividends if it assesses that the stock is undervalued, as part of a move towards debt financing (i.e., taking on more debt), or to meet a short-term share price target. A company might pay dividends if the company’s stock is overvalued, or to provide shareholders with the ability to remain invested in the company while still receiving a regular income stream. Companies may prefer buybacks because they are tax-advantaged, since taxes are due when income is realized as dividends but are deferred until realized when the price of a share increases.

Through Regulation 10b-18, the U.S. Securities and Exchange Commission (SEC) creates a safe harbor for market manipulation liability for buybacks if certain requirements are met. There are four primary methods through which a company can buy back shares:

1. Open market purchase: A company repurchases a certain number of shares on the open market over an extended time. This is the most common repurchase mechanism.
2. Tender offer: A company announces that it will repurchase a certain number of shares at a specific price, allowing shareholders to decide whether to sell them back. This method enables a quick repurchase of shares but is typically more expensive for the company due to a premium paid on shares and administrative costs.
3. Privately negotiated repurchase: A company enters into repurchase agreements with individual shareholders rather than buying on the open market, allowing for quick and large-scale repurchases. These purchases are not protected by Regulation 10b-18 safe harbor and have higher administrative costs.
4. Accelerated share repurchase: A company enters into a forward contract with an investment bank, making an upfront payment for shares borrowed from existing shareholders. The bank later repurchases these shares in the open market, with the company often receiving additional shares or having to return shares or pay cash based on stock performance.

Ultimately, all methods result in shareholders releasing their shares back to the company in exchange for cash.

The Rise of Buybacks

Stock buybacks have been on the rise since the early 1980s when the SEC implemented Rule 10b-18. Between 2003 and 2012, S&P 500 companies spent 54% of their net income on buybacks compared to 37% on dividend payouts. In 2022 alone, U.S. corporations spent over $1 trillion on buybacks.

The growing use of buybacks has led to some concerns that corporations are buying back stock to meet short-term financial targets rather than making long-term investments in capital assets and research and development. Opponents claim that buybacks disproportionately benefit top executives, who hold significant equity in the corporation and therefore reap personal financial gains from short-term rises in stock value. An SEC study found that executives’ sale of personally owned stocks increased from an average of $100,000 per day to $500,000 per day immediately following their companies’ buyback announcement. Experts have also raised concern that an increasing percentage of buybacks are being financed by debt, and that excessive levels of corporate debt may destabilize the economy.

Proponents argue that stock buybacks are not a form of short-termism, but rather play a positive role in the growth of the economy. Researchers have found that stock buybacks are often offset with new issues of low-interest debt, and that the accompanying boosts to the stock market benefit the middle class. Additionally, research and development spending as a percentage of gross domestic product (GDP) continues to rise while the number of patents awarded has tripled over the past 25 years. As critics call on corporations to increase employee wages rather than repurchase shares, defenders argue that alternatives to buybacks, such as dividends or R&D investments, do not necessarily result in higher worker pay either.

Current State of Play

Individuals generally pay between zero and 23.8% tax on dividends depending on their income tax bracket. High-income earners may also be subject to an additional 3.8% net investment income tax. Under current law, the tax rates for qualified dividends are the same as the long-term capital gains tax rate, although this has not always been the case; from 1985 to 2003, dividends were taxed at the same rate as regular income.

Prior to the Inflation Reduction Act of 2022 (IRA), investors paid tax on benefits from a stock buyback through the U.S. capital gains tax when they sold their shares and realized any gains. As a result, foreign shareholders (who may pay foreign taxes on gains) or those who passed on shares after death (due to step-up in basis rules) avoided some U.S. taxation on capital gains. This is one reason stock buybacks are generally thought to be tax-advantaged compared to dividends.

The IRA imposes a 1% excise tax on stock buybacks by publicly traded corporations. The excise tax is non-deductible for companies, can be reduced by new issues to the public or stock issued to employees, and does not apply to buybacks valued at less than $1 million or contributed to employee retirement plans. The Joint Committee on Taxation (JCT) estimates that the excise tax will raise $7.9 billion in FY2024 and $74 billion over the FY2022-FY2031 period. A study from the Tax Policy Center found that, even post-IRA excise tax, the gap between the taxation of dividends and buybacks is about 5% to 8% in favor of buybacks. The authors argued that even with an increase in the excise tax to 4%—the proposed rate in President Biden’s FY2024 budget—buybacks would still be tax-advantaged compared to dividends.

Debt vs. Equity Financing

Issuing equity and taking on debt are the two primary methods companies use to raise capital. Equity financing entails selling a portion of the company’s ownership (and a share of future earnings) in exchange for funds. While this method provides capital without repayment obligations, it also dilutes the company’s ownership and control. When a company buys back their stock and shareholders cash in on their equity, there are fewer shareholders with claims on the equity.

Conversely, debt financing entails borrowing money that must be repaid with interest, allowing owners to retain full control but with additional financial burdens. The choice between these financing options depends on factors such as cash flow, access to funds, and the importance of maintaining control. Companies often use a combination of both when in need of cash. The debt-to-equity ratio helps assess the proportion of a company’s financing sourced from debt versus from equity. Like any investment, companies must have sufficient capital to fund a stock buyback. While some may use cash on hand, other companies are using debt financing to fund buybacks.

The Capital Gains Tax Rate

The direct tax on income derived from the sale of a capital asset is a lower rate than income from labor. This means that most shareholders who realize gains from dividend payouts or buybacks owe tax at the long-term capital gains tax rate, not the individual income tax rate. Common justifications for the differential tax treatment include adjusting the tax for inflation and encouraging saving over consumption. Supporters of the lower capital gains tax rates also argue that capital gains are double taxed: first, corporations pay a 21% corporate tax on profits, and once the after-tax profits are distributed, shareholders pay a tax on realized gains. Some argue that when adjusting for the first layer of taxation, taxpayers in the top tax bracket pay a higher tax rate than just the capital gains rate, closer to 39.8%. However, other research suggests that only a portion of the first layer of corporate taxation is borne by shareholders, although the exact incidence is still up for debate in tax research circles. Opponents of the different tax treatment of capital gains also argue that setting the capital gains tax rate below the labor income tax rate primarily benefits the top 10% of earners and encourages tax-sheltering schemes.

Looking Ahead

Senators on both sides of the aisle have discussed changing the tax rules for stock buybacks. Scholars and experts have proposed several policies that would change how the government taxes buybacks, from increasing the excise tax to implementing a distributed profits tax to treating buybacks as dividends. This is one area worth further research and debate as Congress looks to offset the $5 trillion-plus cost of extending expiring tax cuts next year.