How the IRS Wrongly Allows Stock Buybacks to Evade the Dividend Tax

Abstract

What is a dividend? It is a trillion dollar question. One on which the Internal Revenue Service (IRS) and the courts profoundly disagree.The Tax Code defines a dividend as “any distribution of property made by a corporation to its shareholders.” Corporations found a way around this definition and thus the dividend tax. It involves buying back their own stock. A buyback can act like a dividend in substance, distributing cash to shareholders without changing anyone’s stake in the corporation.This reading has been taken for granted by scholars. We argue the Tax Code provisions are not simple. In fact, the IRS misinterprets them. Most buybacks should actually be taxed as dividends. Congress statutorily drew a line in the sand — buybacks are subject to the dividend tax if they change any non-controlling shareholder’s stake by less than 20%. IRS guidance wrongly moved this line from 20% to >0% — exempting almost all buybacks from the dividend tax. It is as if Congress hung a sign in front of an amusement park ride — “Only people over five feet may enter” — and the IRS read the sign to say, “Only people over zero millimeters may enter.” Yet the IRS says with a straight face, “We maintain a strict height requirement.”Buybacks were virtually unheard of before the IRS made its interpretation clear in 1976. To avoid tax, corporations have since bought back more than $5.7 trillion in stock.We study how the IRS’s mistaken interpretation affects behavior. First, we introduce a theoretical model to prove a dividend tax exemption pushes investors to take more risk than they otherwise would. It essentially offers a tax break to shareholders who reinvest in corporations they already own. Imagine yourself as a RadioShack customer. You can choose to receive 100% money back as a store credit or only 85% money back as a cash refund, since RadioShack deducts a 15% processing fee. Store credit requires you to shop at RadioShack again. A cash refund can be spent at any store.RadioShack management faced a similar dilemma in deciding whether to distribute its earnings to shareholders as a buyback or a dividend. A buyback offers shareholders 100% money back if shareholders reinvest it in RadioShack stock. A cash dividend gives shareholders the freedom to invest in any corporation, but results in a dividend tax.Management generally opted for store credit. From 1995 to 2011, RadioShack spent all its earnings on buybacks — some $3.9 billion — and then borrowed another $1 billion from future earnings to buy back even more stock. On February 5, 2015, RadioShack filed for Chapter 11 bankruptcy protection. Long-term shareholders were wiped out, losing two decades of earnings.When a student makes an error, he earns a bad grade; when a surgeon makes an error, he faces a malpractice claim; but when the IRS makes an error, it creates tax policy.Indeed, an IRS error in favor of the taxpayer generally leaves the courts powerless. The courts are unable to get involved unless someone brings the case. The IRS is, sadly, the only one with standing.Unusual circumstances allowed the courts to overcome this hurdle on four occasions. The Second, Third, Fifth, and Sixth Circuits all rejected the IRS interpretation. But the IRS has refused to acquiesce.