TRADERS
ADVOCACY: TAX CUTS

Our opinions on President Bush's new tax cut plan, specifically the dividend tax cut.

I, Robert Green, CPA, have been pondering the new tax cut proposals from the Bush White House.

So far, I am not very impressed with the dividend tax cut. I think there will be many unintended consequences, some that may hurt our trader clients, and I also think I see through to the White House's real intentions – some I like, some I don't.

No change to the $3,000 capital loss limitation per year:
The new tax cut proposals do not mention any increase in the capital loss limitation, which currently stands at $3,000 per year. I don't see any relief along the lines that GTT sought in our advocacy for trader tax relief and investor tax relief. There was talk the tax cut would increase the loss limitation to as much as $10,000 per year.

Not only did our clients lose on this front, we fear the tax cut has some hidden ways to limit their losses even further (as discussed below). This leads me to believe that this tax cut may be a way for the government to limit general loss deductions in order to protect the budget. The White House talks about "no double taxation," but they really mean "no double loss deductions," and the investor is the one who can't deduct the loss the second time around. In an environment with corporate losses and few profits, it seems the corporations are better positioned for the downside. Unfortunately, the losses will come out of our clients' hides!
Do the new dividend tax cut initiatives mean that a trader won't be able to deduct a capital loss on a company that has already deducted losses?:
The dividend tax cut has some troubling potential consequences and serious questions of practicality in application for business traders. I am concerned with the hidden capital gains tax cut feature in the dividend tax cut. Specifically, if a company has "retained earnings," it may choose to not pay dividends, instead paying taxes on the entity level. The idea of the new tax cut is there should not be double taxation, and if the company pays taxes, the investor should not pay taxes again on their capital gains. This part sounds great, but work through the logic and some troubling questions appear for the reverse case scenario when a company has losses.

The concept of "no double taxation of dividends and retained earnings" has an ugly flip side: no double tax loss recognition for accumulated deficits. Although this is not explicitly mentioned, logically it seems possible. Even more troubling to us is the question of, 'Is the White House trying to protect their budget deficit by changing the tax laws to deny even more loss deductions to investors than currently exist?"

Consider that if most business traders elect mark-to-market accounting (MTM), they will be exempt from the capital loss limitations and be entitled to ordinary loss treatment. If these MTM business traders buy and sell tech stocks and dot.coms (many of which have accumulated deficits rather then retained earnings), the new tax cut plan may prevent them from "double dipping" on their capital losses and may also prevent them from taking many ordinary losses on their trades (assuming they have losing trades). The new tax cut plan will continue to allow the companies to get tax relief for their losses, but it may disallow the investor to get a second round of tax relief on those losses (just as the plan calls for no double taxation, it may also call for no double tax refunds). Imagine how the White House may view the current trading environment. If business traders with MTM lose $200 billion collectively in 2004, the new tax cut may prevent those traders from claiming much of the $100 billion in tax refunds they are entitled to (from filing a Form 1045 Net Operating Loss refund) under the current tax laws.

We think the likelihood of companies having losses and traders having losses is at least as likely as the reverse condition. So far, everyone pushing the tax plan is focusing on the gain scenario, but equal focus should be on the loss scenario.

Here are a few more details: The new tax cut plan proposes that a shareholder should not pay taxes if the corporation paid taxes on that same income, whether it's a dividend paid out of retained earnings (which was subject to U.S. federal taxation) or a "deemed dividend," which is retained earning reinvested in the corporation and not paid out as a dividend. In other words, if Microsoft has earnings, it pays corporate taxes; if it chooses not to pay a dividend, then when its shareholders sell their stock, they can add that retained earnings to their cost basis and thereby realize a lower capital gains tax (or a larger capital loss). So far, this sounds attractive to investors.

Here's my question and concern
If a tech company losses all retained earnings, has an accumulated deficit and receives tax refunds from those entity-level losses (the opposite of paying taxes on earnings), does this mean there should be a "deemed reverse dividend or loss?" In other words, should shareholders not be allowed to "double dip" (the reverse of "double taxation") to again deduct the same losses? The reverse logic of the "deemed dividend" is instead of adding the "deemed dividend" to a shareholder's cost basis, a shareholder would have to reduce their cost basis by the "deemed loss."

The good result promoted by the White House is that shareholders will benefit from the new "no double taxation" laws. I have yet to see any media or tax person talk about the potential consequences to investors and traders with the reverse case scenario of "no double dipping on losses."

The new tax cut plan is being sold as friendly and caring to the new "investor class" in America, and Democrats are arguing it favors the rich class. If we are right about our fears, then the new tax cut plan actually harms the "investor and trader class" and Democrats will use our fears to help kill the plan in the eyes of investors.

Hopefully, Congress and the IRS will see this problem, address it and not disallow double dipping on losses. However, I fear they won't, as they will be charged with carrying out the logic of "no double taxation," which is how the new tax cut is being sold by the White House.

Assuming I am right about our fears on this matter, it will cause further havoc to traders and investors.

There is already a huge problem with investors and traders not being able to deduct their stock market losses. If you want to discuss fairness, that should come first. We think that not giving additional tax loss relief and, in fact, taking away existing loss relief is patently unfair! And the new tax cut plan is supposed to be a marked advance in fairness.

Notice that we never brought up the concept of "non-taxation of dividends" in our investor and trader tax relief advocacy campaigns.

Should traders set up C-Corps to pay a lower tax rate (34 percent) than their current individual rates?:
If you don't tax C-Corps twice on their income (once on the entity-level and then a second time on the shareholder level), then why shouldn't individuals paying a tax rate of greater than 34 percent convert their business to a C-Corp? After all, C-Corps have lower tax rates then the highest individual tax rate (38 percent).

I suspect this is another hidden agenda in the White House. I heard Republican Sen. Charles Grassley (a committee chairman and a key author of the tax cut plan) say on a TV interview that the individual rates should be reduced to the top corporate rates to increase fairness. I believe this is part of the hidden agenda. Open the loophole above and then close it by lowering the individual rates to 34 percent. By the way, I am in favor of lowering the individual tax rates.

The "deemed dividend" capital gains benefit in the new tax cut will be almost impossible to apply to hyperactive traders:
I can not imagine how the new tax cut laws can be applied to hyperactive traders. A company is supposed to report to the investor how much of its retained earnings was subject to an entity-level tax (and paid), and therefore how much the shareholder may add to their cost basis as a "basis adjustment," thereby lowering their capital gains tax or increasing their capital loss.

Hello tax writers! In the real world, how do you propose crafting the regulations to apply to traders who buy and sell a single security 10 times per day? I can only guess that these new provisions will not be applied to traders who don't hold a security for one year. That's good and bad news. The bad news may mean no capital gains tax relief as promised. The good news may be that if they exempt traders from the "deemed dividend" rules, then the traders also won't be penalized by the consequences pointed out above about no double dipping on corporate losses.

The proponents of the new Tax Cut Plan argue that the stock markets will rise to reflect higher dividend payments and after-tax yields. But we think the reverse will happen:
Municipal bond interest is tax-free. Cities don't offer higher yields on their tax-free bonds to beat the competition in taxable yields. Instead, munis pay a lower yield to match taxable yields on an after-tax basis.

We believe that the new tax cut plan is primarily crafted to help corporate America. Just look who is lining up to help pass the new plan! Corporate America will now be able to cut dividends to keep the same after-tax yield, and they may need to do so in the declining earnings market.

Another myth is that corporate America will choose to pay corporate taxes since double taxation is removed:
We believe that corporations will continue to avoid paying taxes using tax shelters and other financially engineered products sold on Wall Street (see our "social tax" campaign allegations). It's all about cash flow. Paying federal taxes is a use of cash flow. Avoiding taxes with financial shenanigans is a source of cash flow. Paying dividends is a use of cash flow. The fiscal incentives in the new tax cut plan, together with existing tax law, will translate to corporate actions that are more of the same – i.e., tax avoidance and non-payment of tax. Under the new plan, the corporations can cut dividends and have the same after-tax yields. So, Uncle Sam is subsidizing the reduction of dividends and continued tax avoidance.

Yes, in some cases, some companies will pay more taxes and pay more dividends. However, we believe they will be drowned out by the others that take advantage of the new tax cut plan for their own advantage.

Here's the bottom line
Read between the new tax cut plan lines, as I have done, and you may then share my opinion that it may be a wolf in a lambs clothing.

Look who wants this plan: the government, corporate America, Wall Street and the financial news media.

The government, whose business is the national and states budgets, is bleeding red ink. We believe the new tax cut plan will raise taxes, if more loss deductions are disallowed. If the environment is more about losses than gains (in corporate profits and trading results), the we might be right. The reverse scenario will apply and "no double taxation" will lead to tax increases.

Corporate America likes any plan that does not reign in their corporate tax shelters and tax avoidance schemes. Furthermore, the plan will give them government subsidies to lower their dividend payments and keep the same after-tax yields as their competition.

Wall Street and the financial news media like the plan because it promises tax relief to investors and traders, and any ray of hope is desperately needed in their eyes.

We don't like the plan because we care about our trader clients, and we fear they may be hurt once again by all the powers that be.

We just wish that someone would listen to our ideas and start helping traders and investors in a real and meaningful way. Smoke and mirrors don't help investors and traders, and they won't help raise the stock markets. Our ideas for new tax initiatives are spelled out at our Tax Reform page.

We hope Washington wakes up and finally starts truly caring about the investor class. If Washington wants investors to reappear in the stock markets it had better start treating them fairly tax-wise. The first step to tax fairness is allowing investors and traders full tax deductibility for their stock market losses to date. We estimate there must be $1 trillion of unused capital losses. This is not a rich person's problem. We have clients filing for bankruptcy because of stock market losses and they are unable to collect tax refunds related to these losses. The majority of brokerage accounts are owned by middle class taxpayers, and most of them are stuck with non-deductible capital losses.

If you want to discuss this with Robert Green, send an e-mail to taxcuts@greencompany.com or call him at (203) 938-4716.

About Robert Green, CPA, and GreenTraderTax.com
Robert Green is the leading authority on trader tax. His virtual tax firm, GreenTraderTax.com has clients across the country. Green is a monthly contributor to Active Trader, the leading magazine for traders, and has been featured in Barron's, Fortune, SmartMoney.com and other publications. He has appeared on CNBC and Bloomberg Television, and has spoken at trader and investor seminars across the country. Green is the author of the popular Trader Tax Guides found on the GreenTraderTax.com Web site. GreenTraderTax.com builds and operates tax centers for leading direct-access brokers and trading schools.